Value Creation In Bank–NBFC Alliances?

Over the last decade, NBFCs in India have scaled up substantially at the cost of banks’ market share, particularly in retail finance. Increasingly, NBFCs are competing with full-service banks for similar customer segments and have been building a loyal customer base with their niche segment-specific solutions.

The recent merger between a new mid-size bank and a retail finance NBFC is an interesting case in point. While the bank was able to strengthen its balance sheet and diversify its asset base, the NBFC gets to access funding at a lower cost and offer a wider suite of products to its customers. The ongoing stressed asset crisis is likely to spur similar consolidation in the NBFC segment.

There is some similarity between the current market and the developments a few years back, when some large NBFCs converted into small finance banks.

Such NBFCs created substantial coverage among the underbanked and were valued for providing the last-mile connect and were also engaged by full-service banks as banking correspondents. However, their finances remained brittle because of the limited balance sheet and dependence on markets for funds.

In 2015-16, after RBI released guidelines on Small Finance Banks (SFBs), the top NBFCs in the MFI sector changed their operating model to function as SFBs. The large full-service banks meanwhile were also making investments to create an ecosystem to reach out to the bottom of the pyramid. In such a competitive scenario, the logical next step for the remaining NBFC-MFIs was to merge with a bank and continue to target the core unbanked segment for the bank. This resulted in multiple mid-sized banks acquiring controlling stakes in such NBFC-MFIs. The acquired NBFCs continued to operate as wholly-owned subsidiaries providing business correspondence services to the acquirer bank.

While the previous situation was the outcome of a regulatory mandate, the current situation originated from concerns of asset-liability management (AML) mismatch in NBFC lending to the infrastructure and realty sectors.

The crisis has taken the form of a contagion and impacted almost all NBFCs. Funding has shrunk as lenders have become extra cautious. Raising fresh equity has become a challenge, as high valuations enjoyed earlier, have now eroded.

When the crisis subsides, funding will be limited to the larger NBFCs with a diversified portfolio and having the backing of a larger conglomerate. Sub-par NBFCs will struggle to raise capital and will seek to divest assets in order to deleverage. NBFCs will need to re-examine the fundamentals of their business, exercising caution over chasing growth, impacting profitability and valuations.

Even until a year ago, NBFCs in the retail or infrastructure finance space were expensive options. The easy availability of capital aided their aggressive growth rate, often at the expense of traditional banks, which further fuelled higher valuations.

The fall in investor confidence is exemplified by the loss in market value of the listed NBFCs, which, as a result, have become attractive targets for strategic acquisitions. This not only gives the banks an opportunity to add assets at attractive valuations, but also use the opportunity to regain some of the market share lost to NBFCs. Although the retail lending space is still dominated by banks, NBFCs have managed to gain a sizeable share in housing finance and auto finance. Acquisitions will enable banks to adopt and execute a differentiated strategy in an otherwise undifferentiated and crowded market. However, banks will need to be careful of the assets they go after and focus on the fit with their strategy in addition to the valuation.