I touched on the importance of the Non-Banking Financial Industry (NBFI) five years ago in the same forum when the industry reforms were on cards. However, since then, the industry has faced many changes. This article is written in order to create an awareness of the industry in the public and to analyse the present situation of the industry with some recommendations to improve it.
The Non-Banking Financial Industry of a country plays a vital role in the economy. It enables the financial intermediation process before the banks. It also facilitates the flow of funds between savers and borrowers. Unlike in banks, it gives high returns to savers and accommodate borderline borrowers who are not welcome by the banks.
With the concept of open economy which was launched in 1977 under the guidance of then President J.R. Jayawardena, the economy of Sri Lanka was booming at a rapid speed. This has paved the way for many industries to flourish. One of them being the financial industry which has a history, dated back to 1930s in Sri Lanka.
The financial institutes that those had been in the industry for a considerable time took the initiative and started to expand their operations in a more aggressive way while a few new players also joined the race. With, old players and new entrants working together, an impact was created in the lives of new and young entrepreneurs of the country. They turned their dreams in to a reality. They were groomed to be the future business leaders. One can say that the Non-Bank Financial Industry has mastered the art of Blue Ocean strategy.
Till 1977, the financial system was dominated by the State banks but in 1977 with the concept of open economy, the country has adopted the policy of financial liberalisation. It was an untamed bull initially, and some of the companies were operating in unprofessional and unethical ways to a larger extent. No controlling mechanism was in place to discipline the industry till 1979.
There was no dedicated legislation for finance companies other than the Companies Act. The Finance Companies Act No. 27 of 1979, brought finance companies under the control the Central Bank of Sri Lanka (CBSL) with the due controls appropriated in that era.
Through this act, it was made mandatory for all finance companies to register under the CBSL. This act has been amended subsequently in two occasions in 1988 and in 1991 by The Finance Companies Act, No. 78 of 1988and Act, No. 23 of 1991. Finance Leasing Act No 56 was introduced in 2000 and The Finance Company Act No 27 was replaced by The Finance Company Act No 42 in 2011. By 2006, 29 Registered Finance Companies (RFCs) were registered under the CBSL. RFCs have been allowed to accept Fixed Deposits from the general public. From 2005 onwards, they were allowed to accept Savings Deposits also from the general public. The business activities of RFCs have been leasing, hire purchase and real estate.
In addition to RFCs, there has been another regulated segment of companies in the financial industry. Those were the Specialised Leasing Companies (SLCs). They were allowed to register at CBSL under the Finance Leasing Act. Currently these two segments are dominating the Non-Banking Financial Industry in Sri Lanka. On two occasions CBSL has made changes to the industry structure. First was in 2011. On that occasion CBSL has upgraded most of the SLCs to RFCs. Second was in 2014. On this occasion CBSL has taken a policy decision to consolidate the Non-Banking Financial Industry. As of 3Q 2017, the industry has had over Rs. 1 trillion net loans and advances in its portfolio. A compounding growth of 23.8% is shown for the last 15 years in its asset base.
This 87-year-old industry is presently having around seven million customers in the form of 57-60% borrowers and 40-43% depositors. It has housed 32,000 employees. Average size of a financial facility is only Rs. 250,000. This means the Non-Banking Financial Industry is a common man’s market.
The industry is funded mainly through public deposits (45%-56%), bank borrowings (32%-35%) and shareholder’s capital infusion (8%-12%). It consists of 35 listed and 17 unlisted finance and leasing companies. While 85% of the industry is dominated by the top 20 players, the balance 15% is shared by the remaining 32 players. Rs. 16.6 b was paid by the industry for the betterment of the country in the last financial year in form of direct taxes. This shows that the Non-Banking Financial Industry is contributing considerably to the national wealth beside its own growth. Alongside the above contribution to the nation, the industry has made an enormous impact in the living standards of the people and per capita income of the country.
The industry’s branch network which consists of around 1,320 branches gives an indication of the reach of the industry to the general public. It indicates every batch of 15,850 people of the population are provided with a Non-Banking Financial Industry branch. This shows the extent to which the industry can influence the people of this country. However, in India by 2010 the country has had 12,630 non-banking financial institutes out of which 308 were allowed to accept public deposits. These figures would have been increased by now drastically from 2010 to 2018.
If it is assumed that each non-banking financial institute has had 10 branches, in today’s context every batch of 10,690 people in India are provided with a Non-Banking Financial Industry’s branch. Does this mean that the Non-Banking Financial Industry in Sri Lanka has a vacuum to be filled? Has it got room for expansion, still? Has that already been filled or encroached by another market segment? A valid point to think of.
In the global context, especially in developing countries, the Non-Banking Financial Industry could be categorised into three types of sub sections, namely, formal, semi-formal and informal sectors. The formal sector consists of financial institutes which are coming under banks, the semi-formal sector consists of mainly the institutes which are registered under the regulator and the informal sector mainly consists of the individuals who are lending to the general public. In the local context the second sector is the main driving force of the industry.
There had been setbacks in the industry from time to time. The collapsing of finance companies started in the late ’80s and early ’90s with the collapse of a few finance companies such as HPT, UTI and MCL. This trend has continued until 2008 at regular intervals with giant companies which thought to be very solid in the eyes of public, crashing down without indicating any prior sign of instability. The last of them being some of the companies of Ceylinco Group and finally CIFL.
The article written by me and published in FT in 2013 stated that one cannot ignore the fact that despite of all the setbacks in the Non-Banking Financial Industry it has contributed fundamentally to the economy of the country for the last 70 to 80 years. Hence, the non-banking financial sector should be nurtured properly to upgrade preschool children of the business world today, for the betterment of the country, tomorrow.
With their product diversification and risk taking ability, they allow new entrants of the business community to experiment in various territories. The Non-Banking Financial Industry ground-level understanding of their customers’ profile and their credit needs give them an edge over their counterparts in the banking industry. Their ability to innovate and customise products as per their clients’ needs is another uniqueness that they possess. This makes them a perfect channel for delivering of credit.
Over my 33 years of experience in the Non-Banking Financial Industry and another four years in the corporate lending industry, I have seen three main segments which drive the development and the growth of the industry. The first of them is the internal policies of individual financial institutions, second is the industry practices as a whole and the third is the fiscal policies governing the industry.
Internal policies of NBFIs
When times are rosy, firms operate comfortably taking risks, enhance their portfolios and look for lucrative returns. But, when risk events occur they get panic and get inflexible. Hence, non-banking financial institutes should improve the way that they look at risk elements, identification mechanism of them and assessing the cost of them. If not, when troubles emerge, those blows could undo the firm grip of control of the companies.
Staff competency is very important in such events. Hence the companies should ensure they have placed adequate staff who are skilful and can sense the risk involved in the industry beforehand in correct positions. Almost all the companies rely on IT-based MIS ratio analysis to gauge overall risk factors. However, some veterans in the industry say that these highly sophisticated methods might not always be correct as they may be over-elaborating issue to a certain extent. The real situation may not be serious as the outcome of these ratios and tests. This might lead in to more threats than precautions.
Non-banking financial institutes should have a good risk management strategy to build its portfolio in more confident manner while taking risks. A highly-disciplined strategy will curtail the business opportunities that those are available in the market. The culture of the company is the key to risk management. The risk has its integrated characteristics. Hence, taking one segment in isolation to evaluate the broader perspective of risk elements is not advisable. It should be looked at from a macro angle with an open mind. A good integrated risk module in an institute helps to boost the ability of developing new products and also creates a better recognition in the books of regulator and rating bodies.
Most say size matters. When the size of the portfolio is big, it can absorb shocks. Hence, a large portfolio is a healthy portfolio. The growth of the portfolio should take place steadily over a period of time. While growing the portfolio, the companies should take a stock count in regular intervals to analyse where they are heading. If not, without their knowledge they might end up in disastrous situations. When some products are behaving in unusual manner to bring sudden windfalls, a careful study should be carried out on such products to ascertain the hidden and unforeseen risk factors.
When unforeseen factors go undetected and companies faced bad situations, those situations should be handled with due care without reacting to the circumstances. In 2012, in the United Kingdom, to overcome a crisis situation, companies and banks were required to set up their own subsidiaries for bad assets management. By doing this they handled the situation in more focused and professional manner. This process was very successful and appropriated as far as the management of bad debts were concerned as dedicated teams were monitoring progress of collections, realisation of assets and the litigation process. The staff of the main company was concentrating on their day to day activities.
Though one time the industry was highly lucrative, presently the Return on Equity (ROE) has deteriorated. It is said that the Return on Assets (ROA) in the industry has declined to around 2-3%. The high interest cost, high bad debt provisions and operating expenses have eaten into the profits of the industry.
The popularity of the Non-Banking Financial Industry is catching up rapidly in the region. As per a study conducted in our neighbouring country India, between the years of 2007 to 2013, the Non-Banking Financial Industry has granted loans, 58% more than the banking industry to the infrastructure industry. The balance sheet and the credit growth of the financial industry has a better impression than the banking industry during the same period. Also, the ROA of the Non-Banking Financial Industry is higher than the banking industry.
The growth comparison of the assets has grown up from 10.7% in 2009 to 14.3% in 2014 in the financial industry against the banking industry. Under the given circumstances the overall performance and the growth of the Non-Banking Financial Industry is better than that of banking industry during the years 2007 to 2013 in India.
In Bangladesh too, the popularity of the Non-Banking Financial Industry has grown rapidly. The Non-Banking Financial Industry portfolio which was at BDT (Bangladesh Takas) 78.84 b in 2000 has grown up to BDT 414.11 b by the end of 2010 which is huge. During the same period GDP has increased to 5.96% from 3.85%. When scrutinising these figures in details it is evident that there is a very strong relationship between the growth of the Non-Banking Financial Industry and GDP.
The regional trends are mostly similar in neighbouring countries, unless otherwise there is an artificially created situation existing. Hence, trend of perception on the industry in the region could be narrowed down to Sri Lankan context. A couple of years before the growth rate was positive and in March 2012 it was high as 42%. However, since March 2017 the growth rate was reduced in the industry and it was 18% against March 2016’s 29.5%, though still there is an average growth. This situation is somewhat an artificially-created situation through fiscal policies, deteriorated GDP growth which has hit a four-year low in 2017 and also due to natural disasters faced by the country.
One of the reasons for the growth rate reduction is the introduction of the Loan to Value direction (LTV) to curtail the growth of leasing industry which had a direct impact on the number of vehicles on roads. Though there were many reasons behind this decision, the main reason given was to cut short the supply of new vehicles to the roads to curtail traffic congestions. The prices of the vehicles too were increased through a duty hike and as a result the buying power of end customer was curtailed. The industry has lost further business opportunities in the market due this price increase.
Though there has been a curtailment of business, the LTV direction which could have enhanced the quality of credit in the industry has boomeranged as banking industry moved in to capture this less risk element in the market by offering very attractive rates. It was like fishing in troubled waters as business opportunities which had been left in the market too have been grabbed by banks. In the absence of level playing field between banking industry and the non-banking industry, for survival the Non-Banking Financial Industry was forced to move in to more risky territories, forgetting their cash cow vehicle leasing.
There was a proposal one time, forwarded to the CBSL, to curtail banking industry’s operations in the leasing market. However, this was challenged and didn’t materialise. Then it was further compromised and proposed a threshold of Rs. 5 m for the banking industry. However, this too didn’t materialise. Under the given circumstances, the Non-Banking Financial Industry has had no choice but to venture in to unknown territories or lesser known territories.
Taking this undue risk, economic slowdown in the country and natural disasters such as floods and drought have influenced NPA (Non Performing Advances) to move up considerably in the industry. However, this risk is being managed by the industry by providing a higher provisioning cover. Comparatively, bad debt provisioning made in the last year is very much higher than the previous year in the industry.
Information for better credit
It is evident in most of the bad cases, adequate and genuine information has not surfaced during the evaluation process. Especially information about the customers’ informal borrowings and the monthly rental commitment of them which are not in the data base of Credit Information Bureau (CRIB was established in 1990 under the Act No. 18 of 1990). This monthly commitment creates a huge deficit in their cash flow. There is trend building in the country to settle formal borrowings by informal borrowings to clear irregular CRIB records and then to revert back to formal borrowings. The cash flow issues of such customers remain the same though the CRIB records are clear.
The above situation would have been avoided if the industry had been geared with up-to-date information of the borrowers. I was privileged enough to face an interview over the phone with the world-renowned research organisation Mckinsey & Company on the financial services space in Sri Lanka, covering the entire banking and non-banking financial spectrum in 2013. During the interview it was transpired that they have global information at their fingertips, even on some of the local clients.
CRIB is equipped with data only of formal borrowings. However, we shouldn’t forget the fact that in similar to the global context, even in the local context that there is a vast but undisclosed money lending market exists in the country. They are smarter than the NBFI as far as the recovery of dues are concerned. They lend at high rates as high as 5% to 10% monthly and 60% -120% annually and recover them with no mercy shown towards the customer. There are narratives in the market to say that some of the customers have been forced to pay their dues at gunpoint or in some instances threating to kidnap their children by these loan sharks.
Under these circumstances, like in most of other countries in the absence of actual records at CRIB or Credit score, intermediate organisations can be set up with pre-evaluated data through research. These organisations can maintain data of customers including data that those have not been mapped by CRIB including informal borrowing data and payment records of utility bills of potential customers.
When compared to countries such as Egypt where repossession of assets is a difficult task and takes about a month to obtain an order for repossession from authorities, we are on a better footing. However, under the present industry situation the Non-Banking Financial Industry could be given more powers such as parate execution rights with appropriate controls. Unlike in the past the Non-Banking Financial Industry is now well controlled by compliance regulations. Hence, these strategies will be appropriated in the present context.
The banking industry too has gone through the same scenario some time back and finally Banks Special Provisions Act No. 4 of 1990 came into play after a long delay. The main intention of Act No. 04 was to provide the banks with speedy recovery of loans in default, which resulted in reducing the cost of funds that has a direct impact to the economic development.
Regulatory framework and fiscal policies
The sector regulatory framework is mainly divided in two sections at the CBSL. Those are statutory examinations and continuous surveillance. These two sections are divided to four sub sections. Those are the capital requirement monitoring, risk management, good governance and other regulatory requirement.
The CBSL is mandated to stabilise the financial system in Sri Lanka. They are empowered by Monetary Law Act, Banking Act, Finance Business Act, Payment and Settlement act and Financial Leasing Act, to do so. The Monetary Board of CBSL is empowered to issue directions to the industry with the view of the stabilising the process.
At present, the regulator CBSL is taking all measures to stabilise the Non-Banking Financial Industry of the country. CBSL conducts on site examinations, closely monitor all compliance requirements and audit whether the correct financial information are published by the industry. In 2014 CBSL has taken a policy decision to consolidate the Non-Banking Financial Industry. This was basically a concept imitated from Malaysia.
In Malaysia, well-managed and efficient small institutes were targeted for acquisitions or mergers in market driven mergers to enhance the larger banks efficiency. The acquiring bank was mainly a larger bank with the Government preference through the regulator.
The regulator, CBSL and as per recommendations of Basel III, the capital infusions are made compulsory in order to test the Non-Banking Financial Industry players for their sustainability. The enhancement in the minimum capital requirement was done with the view of stabilising the industry. All non-banking financial institutes were required to enhance their core capital to Rs. 1,000 m by the end of December, 2017. Some of the companies have failed to meet the deadline and they were granted an extension. Though presently no new licenses are granted by CBSL for the industry, the same could be now waived off as core capital requirement will effectively restricted new entrants to the industry.
By 2021 the core capital requirement will be enhanced to Rs. 2.5 b and the capital adequacy ratio will be increased to 12%. The increase of minimum capital requirements has not only strengthened the industry but it has encouraged the small players to join hands with larger entities to stimulate the industry. However, at present some players in the industry are facing with practical difficulties in doing so.
To mitigate the market risk which has a direct impact on the sustainability of the industry, the government could implement a mechanism to limit usage of brand new and reconditioned vehicles in main cities such as Colombo, Kandy, Galle and Kurunegala, etc., where the per capita income is high (these cities can be branded as super grade cities or level No. 1 cities) to a period of three years after the vehicle is registered in the country.
Once the given period of three years is over, the owners should dispose their vehicles (if they want to continue with the same vehicle a tax could be imposed on the ownership. If someone wants to buy a vehicle which is older than the specified period, same tax could be applied on the purchase) and go for new vehicles. The disposed vehicles can be transferred and used in another group of cities (level No. 2 cities) where the per capita income is lower than the earlier group. The usage in these cities also can be limited to a period of three years or as appropriated. Once the given period is over the same set of vehicles can be transferred and used in level No. 3 cities.
During my career I have travelled extensively in this country on customer inspections. Other than a few cities most of cities around country and roads have ample room to accommodate enough vehicles. It is not fair to take decisions to prepare fiscal policies only by looking at the traffic situation in Colombo and Kandy. By adopting the proposed mechanism, the population of the vehicles could be distributed over the entire country. This will create opportunities to all in this country to own a decent vehicle while the Non-Banking Financial Industry and also other industries such as insurance, spare parts, motor mechanical garages, and vehicle brokers will have plenty of business opportunities to capitalise on. The Government too can improve its revenue through this process.
It is also important to encourage the Non-Banking Financial Industry to equip with adequate staff training and staff training facilities at individual company level and also at industry level. The regulator CBSL too can assist the industry in this aspect. At the recently-concluded FHA CEOs meeting it was aired that most of the issues with the Financial Ombudsman is due to the lack of training and knowledge of industry staff and their poor knowledge on industry norms. Furthermore, special training on detection of fraudulent documents is an essential factor in these training programmes. To have more effective training, it is proposed to obtain the assistance of CID officers or retired CID officers who are specially trained on this characteristic.
Considering the facts stated, it is prudent to look after the Non-Banking Financial Industry by providing it with necessary tools for speedy recovery action, proper training mechanism to pump skilful human resources, mechanism to have credit score for individuals, recognition of private credit agencies to have information of potential new borrowers and also of the existing borrowers, levelling the field to have equal playing conditions for financial industry and the banking industry and creating revolutionising mechanisms through appropriate fiscal policies such as the above-stated mechanism of distribution of vehicles. This will also open the un-bankable and genuine customers in the country with ample opportunities to better their lives.
There is no doubt that the Non-Banking Financial Industry has created a great impact on the country’s economic growth and improved the living standards of people of this country over a considerable period of time. Nursing the Non-Banking Financial Industry should be done sincerely and methodically. If the financial industry is curtailed, the informal money lenders will fill the vacuum.
Those individuals and informal finance entities who are into money lending activities informally are not governed by the CBSL or Government statutes which means the expected good governance, compliance, controls and the discipline will not be met by the industry finally. Under the given circumstances, this intermediate industry which has contributed immensely to the growth of the country’s economy by taking undue risks and scarified a considerable amount of their own earnings and investments during the voyage on exploration over a period of time should be protected for the betterment of the country.
This article is based on some of the findings of the research which I have done during my MBA final research report on NBFI. Due to ethical consideration some of the facts and figures which were found have not been disclosed to maintain their confidentiality.
(The writer, IMSL, is a CEO/General Manager of a non-bank financial institution and counts over 38 years of experience in the corporate world out of which 33 years are in the Non-Banking Financial Industry.)