Unit III

Securitization
Securitization of debt or asset refers to the process of liquidating the illiquid and long term assets
like loans and receivables of financial institutions like banks by issuing marketable securities
against them. It is a technique by which a long term, non-negotiable and high valued financial
assets like hire purchase is converted into securities of small values which can be tradable in the
market like shares.

The various stages involved in the working of securitization are as follows :

(1) Identification – The lending financial institution either a bank or any other institution which
decides to go in for securitization of its assets is called the ‘originator’. The originator might
have got assets comprising of a variety of receivables like commercial mortgages, lease
receivables, hire purchase receivables, etc. The originator has to pick up a pool of assets of
homogeneous nature, considering the maturities, interest rates involved, frequency of repayments
and marketability. This process of selecting a pool of loans and receivables from the asset
portfolios for securitization is called Identification process.

(2) Transfer process – After the identification process is over, the selected pool of assets are then
‘passed through’ to another institution which is ready to help the originator to convert those
pools of assets into securities. This institution is called the special purpose vehicle (SPV) or the
trust. This process of passing through the selected pool of assets by the originator to a SPV is
called transfer process and once this transfer process is over, the assets are removed from the
balance sheet of the originator.

(3) Issue process – After this transfer process is over, the SPV takes up the task of converting
these assets of various types of different maturities. It is on this basis, the SPV issues securities
to investors. The SPV splits the package into individual securities of smaller values and they are
sold to the investing public.

(4) Redemption process – The redemption and payments of interest on these securities are
facilitated by the collections received by the SPV from the securitized assets. The task of
collection of dues is generally entrusted to the originator or a special servicing agent can be
appointed for this purpose. This agency is paid a certain percentage of commission for the
collection services rendered.
(5) Credit rating process – Since the ‘Pass through certificates’ have to be publicly issued, they
require credit rating by a good credit rating agency so that they become more attractive and
easily acceptable. Hence, these certificates are rated at least by one credit rating agency.

Securitisable Assets
The following assets are generally securitized by financial institutions :

(i) Term loans to financially reputed companies

(ii) Receivables from Government departments and companies

(iii) Credit Card receivables

(iv) Hire purchase loans like vehicle loans

(v) Lease finance

(vi) Mortgage loans etc

Benefits of Securitisation
(i) Additional source of fund –

It provides an additional source of funds by converting an otherwise illiquid asset into ready
liquidity. As a result, there is an immediate involvement in the cash flow of the originator. Thus
it acts as a source of liquidity.

(ii) Greater profitability – Securitization helps financial institutions to get liquid cash from
medium term and long term assets immediately rather than over a longer period. It leads to
greater recycling of funds which, in turn, leads to higher business turnover and profitability. The
originator can also act as the receiving and paying agent. It gets additional income in the form of
servicing fee.

(iii) Enhancement of Capital Adequacy ratio – Securitization enables financial institutions to

enhance their capital adequacy ratio by reducing their assets volume. The process of
securitization necessitates the selection of a pool of assets by the financial institutions to be sold
or transferred to another institution called SPV. Once the assets are transferred, they are removed
from the balance sheet of the originator. Capital adequacy ratio can also be improved by
replacing the loan assets with the lesser risk weighted assets.
(iv) Spreading of credit risk – Securitization facilities the spreading of credit risk to different
parties involved in the process of securitization. The originator is able to diversify the risk factors
among the various parties involved in the securitization. Thus, securitization helps to achieve
diversification of credit risks which are greater in the case of medium term long term loans.
Thus, it is used as tool for risk management.

(v) Lower cost of funding – Securitization enables the originator to have an easy access to the
securities market at debt ratings higher than its overall corporate rating. It means that companies
with low credit rating can issue asset backed securities at lower cost due to high credit rating on
such securities. This helps it to secure funds at lower cost.

(vi) Provision of multiple instruments – From the investor’s point of view, securitization
provides multiple new investment instruments so as to meet the varying requirements of the
investing public. It also offers varieties of instruments for other financial intermediaries like
mutual funds, insurance companies, pension funds etc giving them many choices.

(vii) Prevention of Idle Capital – In the absence of Securitization, capital would remain idle in
the form of ill-liquid assets like mortgages, term loans etc., in many of the lending institutions.
Securitization helps in recycling of funds by converting these assets into liquidity, liquidity into
assets, assets into liquidity by means of issuing tradable and transferable securities against these
assets.

(viii) Better than Traditional Instruments – Certificates are issued to investors against the
backing of assets securitized. The underlying assets are used not only as a collateral to the
certificates by also to generate the income to pay the principal and interest to the investors.

AUTO LOAN SECURITIZATION

Auto loan securitization is essentially retail collateral, as auto finance is essentially a variant of
consumer finance. Other consumer finance receivables include the receivables arising out of
typical consumer finance and installment credit transactions.
Forms of installment credit have been prime movers of auto sales in recent years. At certain
phases in the economic cycle, auto finance becomes the most important way of selling vehicles.
In most markets, a larger part of vehicles sales are installment-funded than are bought with
consumer equity.
If auto financing is the key to auto sales, auto loan securitization is the key to refinancing of auto
loan transactions. In various countries, there prevail different modes of funding of vehicles such
as
• Secured loans
• Conditional sales
• Hire purchase
• Financial leases
• Operating leases

In a broad sense, auto loan securitization covers each of these methods of funding, except for the
last one. Operating leases and rentals are a different product in view of the nature of the cash
flow and the inherent risks.
Outside the mortgage-backed market, auto loan securitization was the second application of
securitization, the first being computer lease securitization. Captive finance companies of the Big
3—Ford Motor Credit Co., General Motors Corp., and DaimlerChrysler—are the leading issuers
of auto-loan-backed securities.

RBI proposes new rules for mortgage securitization :

The central bank would explore measures such as loan contract standards.
The central bank is proposing new rules to securitise mortgages and enhance their marketability,
making it easier for home financiers and para banks to access cash and adding momentum to
India’s corporate loans market.

The Reserve Bank of India’s (RBI) move would make additional liquidity available to non-
banking finance companies (NBFC), which have a significant share in overall credit
disbursement but are struggling to raise funds cheaply after the IL&FS defaults.

To enable better management of credit and liquidity risks on the balance sheets of banks and
HFCs and help lower the costs of mortgage finance in the economy, the RBI would constitute a
committee that will assess the state of India’s housing finance securitisation market.
The panel would study international best practices and lessons from the global financial crisis to
propose measures that would help develop these markets locally. It would come up with
definitions of conforming mortgages, mortgage documentation standards, and digital registry for
ease of due diligence and verification by investors.

“Recognising the benefits of an active secondary market in loans, the Reserve Bank will set up a
task force to study the relevant aspects, including best international practices, and propose
measures for developing a thriving secondary market for corporate loans in India,” said RBI in a
statement.

The central bank would explore measures such as loan contract standards, digital loan contract
registry, ease of due diligence and verification by potential loan buyers, online platform for loan
sales and auctions, and accessible archive of historical market data on bids and sale prices for
loans. RBI believes that the secondary market for loans can be an important mechanism for
credit intermediaries to manage credit risk and liquidity risk on their balance sheets, especially
for distressed assets.

“Loan sales can facilitate risk transfer across intermediaries that originate credit, such as banks
and non-banking financial companies, and from credit originators to intermediaries, such as asset
restructuring companies (ARCs), private equity (PE) funds, and alternative investment funds
(AIFs),” said RBI.

At present, the secondary market for corporate loans in India is dominated by transactions of
banks in non-performing assets and is constrained by sparse information on pricing and recovery
rates. “The proposal to set up a committee on housing securitization markets and task force for
secondary markets for corporate loans is a positive announcement for long-term development of
the credit supply mechanism by attracting a wider set of investors,” said Karthik Srinivasan,
Group Head, financial sector ratings, ICRA. “…The current model of credit supply in both these
segments is largely to originate the loan and hold until maturity.”
In the securitisation market, mortgage originators package portfolios and resell them in capital
markets as mortgage-backed securities or covered bonds. The securitisation market is dominated
by direct assignment and purchase of loan receivables of non-banks, including housing finance
companies, by banks.

Insurance
A contract whereby one party, called ‘the insurer or the insurance company’, undertakes to
compensate the other party called the ‘insured’, for any loss or damage suffered by the latter, in
consideration of payment of premium’ for a certain period of time, is known as ‘insurance’.

Basic principles of Insurance

(1) Good faith – A contract of insurance is based on the principle of ‘utmost good faith’.
Accordingly, both parties to the contract are required to disclose all material facts.

(2) Insurable interest – The insured party is required to have an insurable interest on the object
on which the insurance policy is taken. Insurable interest is required to be present both at the
time of the contract, as well as at the time of loss. This implies that loss or damage caused such
an object would cause financial loss to the insured party.

(3) Compensation – An insurance contract undertakes to indemnify the insured for any loss or
damage sustained due to the risk against which it is insured. This is applicable only to the general
insurance business, where it is possible to calculate the loss or the damage in terms of money.

(4) Subrogation – The term ‘subrogation’ refers to stepping into the shoes of others.
Accordingly, an insurer can step into the shoes of an insured and become entitled to all the rights
and privileges of the insured in relation to the insured object, after making payment to the
insured.

(5) Contribution – The amount of compensation forthcoming from an insurance company would
depend proportionately on the amount for which the insurance policy has undertaken to
compensate for the loss.
(6) Loss mitigation – In order that the insurance company makes a reasonable payment of claims,
it is necessary that the insured party takes all the necessary steps to mitigate the risk of loss in the
event that the contingency insured against occurs. The insured must act as a person of ordinary
prudence, and should make all reasonable efforts to minimize the loss.

(7) Causa Proxima – Risk coverage is available to the insured party, provided the loss has
occurred directly from such events as specified in the insurance policy.

Life Insurance
A contract in which the insurer undertakes to pay a certain sum of money to the insured, either
on the expiry of a specified period or on the death of the insured, in consideration of payment of
‘premium’ for a certain period of time is known as ‘Life Insurance’. Life insurance serves the
purpose of protection as well as an investment contract. It is a protection contract because it
gives protection to the assured in the event of death, by making payment of the entire amount of
the ‘sum assured’.

Policies
(1) Whole Life policy – An ordinary policy which runs throughout the life of the assured is
known as ‘whole life policy’. The sum assured under this policy is payable only after the death
of the assured. The premium payable is low, and is meant to protect the family.

(2) Endowment policy - The policy runs for a period as specified in the policy document. The
sum assured along with the bonuses, are payable either on the date of maturity of the policy, or
on the death of the assured, whichever occurs earlier. This policy offers the advantage of both
protection and investment.

(3) Annuity policy – Under this policy, the amount of the policy is paid in the form of annuities
for a specified number of years, or till the death of the assured.

(4) Joint Life policy – when the insurance policy covers the lives of two or more persons.

(5) Group Insurance policy – When an insurance is taken out on the lives of the members of a
family, or the employees of a business concern.

General Insurance
A contract whereby upon periodic payment of a sum of money called premium, the insurer
undertakes to compensate the insured in the event of any specified loss or damage suffered by
the latter is known as General Insurance.

Types of General Insurance

(1) Fire Insurance – The insurance company undertakes to indemnify the loss sustained by the
insured party on account of fire accidents. In order that fire claims are admitted by the insurance
company, there must be an actual fire that is accidental, and not intentional.

(2) Marine Insurance – An insurance contract which covers the risks of loss arising from and
incidental to marine adventure is known as ‘Marine insurance’. The kinds of risk that are covered
in this type of insurance are cargo, Hull, freight etc. Cargo insurance covers the risks arising
from an act of God, enemy, fire, gales etc. Hull insurance covers the risk caused to the ship
during the voyage. Freight insurance covers risks arising from the non-payment of freight
charges to the owner of the ship on account of the perils of the sea voyage.

Liability Insurance

A type of insurance contract that provides insurance protection to a person in the event of
damage caused to someone’s health or property, if found to be at fault is called ‘Liability
Insurance’.

Other Insurances

There are other popular type of general insurance which includes motor insurance, burglary, theft
and robbery insurance.

Insurance Regulatory and development Authority (IRDA)

Composition

The IRDA was constituted by an act of Parliament under Section 4 of IRDA Act 1999. The
Authority is a ten member team consisting of a Chairman, five whole time members and four
part time members, all appointed by the Government of India.
Duties

Under Section 14 of the IRDA Act, the Authority’s duty is to regulate, promote and to ensure an
orderly growth of the insurance and the re-insurance business.

Powers and functions

1) Registration – Issuance of certificate of registration or to renew, modify, withdraw, suspend or

cancel such registration.

2) Protection – Protection of interests of policy holders in matters concerning assigning of

policy, nomination by policy holders, insurable interest, settlement of insurance claim, surrender
value of policy and other terms and conditions in contracts of insurance.

3) Qualification – Specifying the requisite qualifications, code of conduct and practical training
for insurance intermediaries and agents.

4) Code of conduct – Specifying the code of conduct for surveyors and loss assessors.

5) Efficiency – Promotion efficiency in the conduct of the insurance business.

6) Professionalism – Promoting and regulating professional organizations connected with the

insurance and re-insurance business.

7) Fees etc – Levying fees and other charges for carrying out the objectives of this Act.

8) Information – Calling for information from, undertaking inspection of and conducting

enquiries and investigations, including audit of the insurers, intermediaries, insurance
intermediaries and other organizations connected with the insurance business.

9) Terms of business – Control and regulation of the rates, advantages, terms and conditions that
may be offered by insurers for general insurance, business not so controlled and regulated by the
Tariff Advisory Committee under Section 64U of the Insurance Act, 1938.

10) Books of accounts – Specifying the form and the manner in which books of account shall be
maintained and statement of accounts shall be rendered by insurers and other insurance
intermediaries.

11) Funds investment – Regulating investment of funds by insurance companies.

12) Margin of Solvency – Regulating the maintenance of margin of solvency.

13) Supervising – Supervising the functioning of the Tariff Advisory Committee.

14) Premium income – Specifying the percentage of the premium income going into finance
schemes for promoting and regulating professional organizations pursuing assurance business.

15) Rural Insurance – Specifying the percentage of life insurance business and general insurance
business to be undertaken by the insurer in the rural or social sector.

Non-Banking Financial Company (NBFC)

1. What is a Non-Banking Financial Company (NBFC)?

A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act,
1956 engaged in the business of loans and advances, acquisition of
shares/stocks/bonds/debentures/securities issued by Government or local authority or other
marketable securities of a like nature, leasing, hire-purchase, insurance business, chit business
but does not include any institution whose principal business is that of agriculture activity,
industrial activity, purchase or sale of any goods (other than securities) or providing any services
and sale/purchase/construction of immovable property. A non-banking institution which is a
company and has principal business of receiving deposits under any scheme or arrangement in
one lump sum or in installments by way of contributions or in any other manner, is also a non-
banking financial company (Residuary non-banking company).

2. What does conducting financial activity as “principal business” mean?

Financial activity as principal business is when a company’s financial assets constitute more than
50 per cent of the total assets and income from financial assets constitute more than 50 per cent
of the gross income. A company which fulfils both these criteria will be registered as NBFC by
RBI. The term 'principal business' is not defined by the Reserve Bank of India Act. The Reserve
Bank has defined it so as to ensure that only companies predominantly engaged in financial
activity get registered with it and are regulated and supervised by it. Hence if there are
companies engaged in agricultural operations, industrial activity, purchase and sale of goods,
providing services or purchase, sale or construction of immovable property as their principal
business and are doing some financial business in a small way, they will not be regulated by the
Reserve Bank. Interestingly, this test is popularly known as 50-50 test and is applied to
determine whether or not a company is into financial business.

3. NBFCs are doing functions similar to banks. What is difference between banks &
NBFCs?
NBFCs lend and make investments and hence their activities are akin to that of banks; however
there are a few differences as given below:

i. NBFC cannot accept demand deposits;

ii. NBFCs do not form part of the payment and settlement system and cannot issue cheques
drawn on itself;

iii. deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is not
available to depositors of NBFCs, unlike in case of banks.

4. Is it necessary that every NBFC should be registered with RBI?

In terms of Section 45-IA of the RBI Act, 1934, no Non-banking Financial company can
commence or carry on business of a non-banking financial institution without a) obtaining a
certificate of registration from the Bank and without having a Net Owned Funds of ₹ 25 lakhs
(₹ Two crore since April 1999). However, in terms of the powers given to the Bank, to obviate
dual regulation, certain categories of NBFCs which are regulated by other regulators are
exempted from the requirement of registration with RBI viz. Venture Capital Fund/Merchant
Banking companies/Stock broking companies registered with SEBI, Insurance Company holding
a valid Certificate of Registration issued by IRDA, Nidhi companies as notified under Section
620A of the Companies Act, 1956, Chit companies as defined in clause (b) of Section 2 of the
Chit Funds Act, 1982,Housing Finance Companies regulated by National Housing Bank, Stock
Exchange or a Mutual Benefit company.

5. What are the requirements for registration with RBI?

A company incorporated under the Companies Act, 1956 and desirous of commencing business
of non-banking financial institution as defined under Section 45 I(a) of the RBI Act, 1934 should
comply with the following:

i. it should be a company registered under Section 3 of the companies Act, 1956

ii. It should have a minimum net owned fund of ₹ 200 lakh. (The minimum net owned fund
(NOF) required for specialized NBFCs like NBFC-MFIs, NBFC-Factors, CICs is indicated
separately in the FAQs on specialized NBFCs)

6. What is the procedure for application to the Reserve Bank for Registration?

The applicant company is required to apply online and submit a physical copy of the application
along with the necessary documents to the Regional Office of the Reserve Bank of India. The
application can be submitted online by accessing RBI’s secured
website https://cosmos.rbi.org.in . At this stage, the applicant company will not need to log on to
the COSMOS application and hence user ids are not required. The company can click on
“CLICK” for Company Registration on the login page of the COSMOS Application. A window
showing the Excel application form available for download would be displayed. The company
can then download suitable application form (i.e. NBFC or SC/RC) from the above website, key
in the data and upload the application form. The company may note to indicate the correct name
of the Regional Office in the field “C-8” of the “Annex-I dentification Particulars” in the Excel
application form. The company would then get a Company Application Reference Number for
the CoR application filed on-line. Thereafter, the company has to submit the hard copy of the
application form (indicating the online Company Application Reference Number, along with the
supporting documents, to the concerned Regional Office. The company can then check the status
of the application from the above mentioned secure address, by keying in the acknowledgement
number.

7. What are the essential documents required to be submitted along with the application
form to the Regional Office of the Reserve Bank?

The application form and an indicative checklist of the documents required to be submitted along
with the application is available at www.rbi.org.in → Site Map → NBFC List → Forms/
Returns.

8. What are systemically important NBFCs?

NBFCs whose asset size is of ₹ 500 cr or more as per last audited balance sheet are considered
as systemically important NBFCs. The rationale for such classification is that the activities of
such NBFCs will have a bearing on the financial stability of the overall economy.

B. Entities Regulated by RBI and applicable regulations

9. Does the Reserve Bank regulate all financial companies?

No. Housing Finance Companies, Merchant Banking Companies, Stock Exchanges, Companies
engaged in the business of stock-broking/sub-broking, Venture Capital Fund Companies, Nidhi
Companies, Insurance companies and Chit Fund Companies are NBFCs but they have been
exempted from the requirement of registration under Section 45-IA of the RBI Act, 1934 subject
to certain conditions.

Housing Finance Companies are regulated by National Housing Bank, Merchant Banker/Venture
Capital Fund Company/stock-exchanges/stock brokers/sub-brokers are regulated by Securities
and Exchange Board of India, and Insurance companies are regulated by Insurance Regulatory
and Development Authority. Similarly, Chit Fund Companies are regulated by the respective
State Governments and Nidhi Companies are regulated by Ministry of Corporate Affairs,
Government of India. Companies that do financial business but are regulated by other regulators
are given specific exemption by the Reserve Bank from its regulatory requirements for avoiding
duality of regulation.

It may also be mentioned that Mortgage Guarantee Companies have been notified as Non-
Banking Financial Companies under Section 45 I(f)(iii) of the RBI Act, 1934. Core Investment
Companies with asset size of less than ₹ 100 crore, and those with asset size of ₹ 100 crore and
above but not accessing public funds are exempted from registration with the RBI.
10. What are the different types/categories of NBFCs registered with RBI?

NBFCs are categorized a) in terms of the type of liabilities into Deposit and Non-Deposit
accepting NBFCs, b) non deposit taking NBFCs by their size into systemically important and
other non-deposit holding companies (NBFC-NDSI and NBFC-ND) and c) by the kind of
activity they conduct. Within this broad categorization the different types of NBFCs are as
follows:

I. Asset Finance Company (AFC) : An AFC is a company which is a financial institution

carrying on as its principal business the financing of physical assets supporting
productive/economic activity, such as automobiles, tractors, lathe machines, generator sets, earth
moving and material handling equipments, moving on own power and general purpose industrial
machines. Principal business for this purpose is defined as aggregate of financing real/physical
assets supporting economic activity and income arising therefrom is not less than 60% of its total
assets and total income respectively.

II. Investment Company (IC) : IC means any company which is a financial institution carrying
on as its principal business the acquisition of securities,

III. Loan Company (LC): LC means any company which is a financial institution carrying on as
its principal business the providing of finance whether by making loans or advances or otherwise
for any activity other than its own but does not include an Asset Finance Company.

IV. Infrastructure Finance Company (IFC): IFC is a non-banking finance company a) which
deploys at least 75 per cent of its total assets in infrastructure loans, b) has a minimum Net
Owned Funds of ₹ 300 crore, c) has a minimum credit rating of ‘A ‘or equivalent d) and a
CRAR of 15%.

V. Systemically Important Core Investment Company (CIC-ND-SI): CIC-ND-SI is an NBFC

carrying on the business of acquisition of shares and securities which satisfies the following
conditions:-

(a) it holds not less than 90% of its Total Assets in the form of investment in equity shares,
preference shares, debt or loans in group companies;

(b) its investments in the equity shares (including instruments compulsorily convertible into
equity shares within a period not exceeding 10 years from the date of issue) in group companies
constitutes not less than 60% of its Total Assets;

(c) it does not trade in its investments in shares, debt or loans in group companies except through
block sale for the purpose of dilution or disinvestment;

(d) it does not carry on any other financial activity referred to in Section 45I(c) and 45I(f) of the
RBI act, 1934 except investment in bank deposits, money market instruments, government
securities, loans to and investments in debt issuances of group companies or guarantees issued on
behalf of group companies.
(e) Its asset size is ₹ 100 crore or above and

(f) It accepts public funds

VI. Infrastructure Debt Fund: Non- Banking Financial Company (IDF-NBFC) : IDF-NBFC is a
company registered as NBFC to facilitate the flow of long term debt into infrastructure projects.
IDF-NBFC raise resources through issue of Rupee or Dollar denominated bonds of minimum 5
year maturity. Only Infrastructure Finance Companies (IFC) can sponsor IDF-NBFCs.

VII. Non-Banking Financial Company - Micro Finance Institution (NBFC-MFI): NBFC-MFI is a

non-deposit taking NBFC having not less than 85% of its assets in the nature of qualifying assets
which satisfy the following criteria:

a. loan disbursed by an NBFC-MFI to a borrower with a rural household annual income not
exceeding ₹ 1,00,000 or urban and semi-urban household income not exceeding ₹ 1,60,000;

b. loan amount does not exceed ₹ 50,000 in the first cycle and ₹ 1,00,000 in subsequent cycles;

c. total indebtedness of the borrower does not exceed ₹ 1,00,000;

d. tenure of the loan not to be less than 24 months for loan amount in excess of ₹ 15,000 with
prepayment without penalty;

e. loan to be extended without collateral;

f. aggregate amount of loans, given for income generation, is not less than 50 per cent of the total
loans given by the MFIs;

g. loan is repayable on weekly, fortnightly or monthly instalments at the choice of the borrower

VIII. Non-Banking Financial Company – Factors (NBFC-Factors): NBFC-Factor is a non-

deposit taking NBFC engaged in the principal business of factoring. The financial assets in the
factoring business should constitute at least 50 percent of its total assets and its income derived
from factoring business should not be less than 50 percent of its gross income.

IX. Mortgage Guarantee Companies (MGC) - MGC are financial institutions for which at least
90% of the business turnover is mortgage guarantee business or at least 90% of the gross income
is from mortgage guarantee business and net owned fund is ₹ 100 crore.

X. NBFC- Non-Operative Financial Holding Company (NOFHC) is financial institution through

which promoter / promoter groups will be permitted to set up a new bank .It’s a wholly-owned
Non-Operative Financial Holding Company (NOFHC) which will hold the bank as well as all
other financial services companies regulated by RBI or other financial sector regulators, to the
extent permissible under the applicable regulatory prescriptions.
What are the various prudential regulations applicable to NBFCs?

The Bank has issued detailed directions on prudential norms, vide Non-Banking Financial
(Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2007,
Non-Systemically Important Non-Banking Financial (Non-Deposit Accepting or Holding)
Companies Prudential Norms (Reserve Bank) Directions, 2015 and Systemically Important Non-
Banking Financial (Non-Deposit Accepting or Holding) Companies Prudential Norms (Reserve
Bank) Directions, 2015. Applicable regulations vary based on the deposit acceptance or systemic
importance of the NBFC.

The directions inter alia, prescribe guidelines on income recognition, asset classification and
provisioning requirements applicable to NBFCs, exposure norms, disclosures in the balance
sheet, requirement of capital adequacy, restrictions on investments in land and building and
unquoted shares, loan to value (LTV) ratio for NBFCs predominantly engaged in business of
lending against gold jewellery, besides others. Deposit accepting NBFCs have also to comply
with the statutory liquidity requirements. Details of the prudential regulations applicable to
NBFCs holding deposits and those not holding deposits is available in the section ‘Regulation –
Non-Banking – Notifications - Master Circulars’ in the RBI website.

Classification The Development Finance Institutions can be classified into four categories:
• National Development Banks Ex: IDBI, SIDBI, ICICI, IFCI,
• Sector specific financial institutions Ex: TFCI, EXIM Bank, NABARD, HDFC, NHB
• Investment Institutions Ex: LIC, GIC and UTI
• State level institutions Ex: State Finance Corporations and SIDCs.

Development Financial Institutions (DFIs) in India

History of Development
Development Financial Institutions (DFIs) were established with the Government support for
underwriting their losses as also the commitment for making available low cost resources for
lending at a lower rate of interest than that demanded by the market for risky projects. In the
initial years of development it worked well. Process of infrastructure building and
industrialization got accelerated. The financial system was improved considerably as per the
needs of projects.
Appraisal system of long term projects had also been strengthened due to improvement in
availability of information and skills. Thus, the DFIs improved their appetite for risk associated
with such projects. “The intermediaries like banks and bond markets became sophisticated in risk
management techniques and wanted a piece of the pie in the long term project financing. These
intermediaries also had certain distinct advantages over the traditional DFIs such as low cost of
funds and benefit of diversification of loan portfolios”.
The government support to DFI was also declining due to fiscal reasons or building the market
more competitive and efficient. Fiscal imperatives and market dynamics have forced the
government to undertake reappraisal of its policies and strategy with regard to the role of DFIs in
Indian system. However, it is important to note that our country has not achieved its develop-
ment goals even then due to unavoidable circumstances like economic reforms we have started
the restructuring process of DFIs after 1991.

Development Financial Institutions (DFIs) in India – Role of Development

Role of development finance may be evaluated in following ways:
(i) It is supposed to identify the gaps in efficacy of institutions and markets and act as a ‘gap-
filler’.
(ii) It makes up for the failure of financial markets and institutions to provide certain kinds of
finance to economic agents who are really interested to improve the working of economy.
(iii) It targets at economic activities or agents, which are rationed out of market. It motivates the
agent to take risky business with venture finance.
(iv) It helps the funds seekers by providing concessional funds at lower rate of return. Social
return of DFIs is quite high. Keeping these facts in mind central banking system also supports
development financial institutions.
(v) It is specialized in nature and involved long term finance. It is exclusively meant for
infrastructure and industry, finance for agriculture and small and medium enterprises (SME)
development and financial products for certain sections of the people who needs funds for
development perspectives.

Development Financial Institutions (DFIs) in India – Nature of Development

Diamond William (1957) defines development institutions as “an institution to promote and
finance enterprises in the private sector”. According to Boskey Shirley, “The development banks
are, institutions, public/private, which have one of their principal functions, as the making of
medium and long term investment in the industrial projects”. According to Nyhart and Janssens
development banks are ‘ those institutions, which provide general medium term and long-term
financial assistance to a developing economy”.
The World Development Report (1989) defines, “financial intermediaries are those, which
emphasis the provision of capital (loans and equity) for development. It may specialize in
particular sector, for example, industry, agriculture or housing”.
Hook (1976), also suggests, that the development banks have two functions to perform i.e.
banking and development.” As a banker, the development banks are expected to finance those
projects, which are “Bankable”. A project is bankable if it is in the nature of self-financing.
Elaborating self-financing projects, Kane J.A. says that “a project is self- financing, if it is able to
generate enough income within a specified period of time to (i) cover the cost of operations,
(once the plants begin the operations), (ii) repay the principle and interest charges thereon and
(iii) lease a residual profits enough to remain in the operations.”
It is specialized mode of extending development finance and it is generally called as
development financial institution (DFI) or development bank. A DFI is defined as “an institution
promoted or assisted by the government to provide development finance to sectors of the
economy. The institution distinguishes itself by a judicious balance as between commercial
norms of operation, as adopted by any private financial institution, and developmental
obligations; it emphasizes the “project approach”.
A development bank is expected to upgrade the managerial and the other operational pre-
requisites of the assisted projects. Its insurance against default is the integrity, competence and
resourcefulness of the management, the commercial and technical viability of the project and
above all the speed of implementation and efficiency of operations of the assisted projects. Its
relationship with its clients is of a continuing nature and of being a “partner” in the project than
that of a mere “financier”.
These definitions outlined the pervasive nature of the development banks. There are different
types of promoters for DFIs. Some DFIs are found to be the government sponsored, others are
privately owned, and still others are in both hands. These DFIs are engaged in providing
different types of services. Promotional and entrepreneurial services are the main theme of these
DFIs. These services carry a commitment towards faster growth and fulfilment of the aspirations
of the economy.
Thus, the DFIs are necessary for long-term finance and other assistance for activities or sectors
of the economy. In emerging sectors risks may be higher than that the ordinary financial system
and they are unable to bear the risks involved. They have also been playing effective role in
stimulating equity and debt markets by- (i) selling their own stocks and bonds; (ii) helping the
assisted enterprises float or place their securities and (iii) selling from their own portfolio of
investments.
In this way, “a development bank is intended to provide a necessary capital, enterprise,
managerial and technical know-how as these are inadequate in developing economy like India.
They also assist in building up the financial and socio-economic infrastructure, favourable to
quick economic development. The emphasis on its various activities has shifted from one
country to another according to its peculiar needs and circumstances. In some countries the stress
has been on finance; in some others, on promotion; yet in others on technical skill and advice;
and again elsewhere on economic planning itself.”

Development Financial Institutions (DFIs) in India – Forms and Types of DFIs in India
DFIs can be broadly categorised as all-India or state/regional level institutions depending on
their geographical coverage of operation.

Functionally, all-India institutions can be classified as:

(i) Term-lending institutions (IFCI Ltd., IDBI, IDFC Ltd., IIBI Ltd.) extending long- term
finance to different industrial sectors,
(ii) Refinancing institutions (NABARD, SIDBI, NHB) extending refinance to banking as well as
non-banking intermediaries for finance to agriculture, SSIs and housing sectors,
(iii) Sector-specific/specialised institutions (EXIM Bank, TFCI Ltd., REC Ltd., HUDCO Ltd.,
IREDA Ltd., PFC Ltd., IRFC Ltd.), and
(iv) Investment institutions (LIC, UTI, GIC, IFCI Venture Capital Funds Ltd., ICICI Venture
Funds Management Co. Ltd.). State/regional level institutions are a distinct group and comprise
various SFCs, SIDCs and NEDFi Ltd.

Development Financial Institutions (DFIs) in India – Rationale of DFIs in India

The DFIs were set up in India on the following rationale:

(i) Improving Rates of Savings and Investment:

In initial years rate of capital formation was low. At the time of independence saving rate was
around at 5 per cent of national income. India had a fairly diversified industrial base for a
developing country, with a number of well-established industrial houses at the time of inde-
pendence. So necessary guarantee was expected from the DFIs otherwise entrepreneurs and
promoters would have not been able to generate resources from the market.

(ii) Infancy Stage of Capital Market:

The capital market was at infancy stage and industries had to depend on their own profits and
banks for financing for further development programmes. That is why these funds institutions,
investment institutions, other trusts, etc. has been declared as DFIs in terms of public financial
institutions (PFI) under Section IV-A of Companies Act, 1956.
(iii) Risk Averse Commercial Bank:
Commercial banks were not interested in venture financing as they are quite risky one. DFIs are
specialised financial institutions and well equipped in risky venture.

(iv) Arrangement of Loan in Foreign Currency:

Earlier, DFIs had access to lines of credit in foreign currencies from various multilateral and
bilateral agencies at low rates of interest mainly for project financing. The Central Government
had assumed all foreign currency risks due to fluctuation in the exchange rates.

(v) Specialized Credit Support System:

DFIs could sanction and disburse credit at fixed/assured rates spread over their borrowing rates
till the early 1990. Moreover, under the existing industrial licensing policy system obtaining a
license itself was taken as license to get credit from DFIs, without the investor going through the
elaborate procedures normally associated with projected appraisal for credit sanction based on
commercial judgment and viability.

(vi) Arrangement of Priority Sector Financing:

DFIs did not have competition in deploying their funds to public companies. However, some
commercial banks had started providing term capital as priorities for investments in various
sectors in the economy were given, along with targets set in successive plans.

(vii) Project Evaluation and Funding:

Some DFIs had also conducted economic potential surveys of regions or states and provided
considerable support to a number of development projects. When project costs were high and
could not be financed by one DFI, they formed loan consortia with commercial banks whereby
DFIs could provide large sized loans thereby reducing the incidence of risks.

(viii) Coordinating Financing Agencies:

The DFIs were expected to work as conduits between the government/other financing agencies
and the ultimate borrowers for an assured margin. They also acquired skills and expertise to
study the viability and technical efficiency of projects which was called as the directly produc-
tive activities.

Development Financial Institutions (DFIs) in India – Challenges before DFIs

The DFIs are facing the following challenges:
(i) Problems in Mobilisation of Resources:
The DFIs have to mobilize funds from the market but they suffered from structural inflexibility
as they did not have good network of branches all over the country. There are restrictions on the
amount of funds that could float in the market. Now interest rates are quite competitive and these
DFIs are not getting funds at competitive rates.

(ii) Problem of Competitive Interest Rate:

The DFIs have to also cut down their lending rates to levels set by commercial banks and also
provide access to their funds as liberally as the banks without, a matching reduction in their own
borrowing costs. The DFIs are not habitual of flexible interest rates and they are losing their
business from the corporate sector.

(iii) Removal of Concessional Rate Regime:

DFIs’ access to borrowings from the Central Government at a highly concessional rate of interest
was withdrawn in a phased manner, since the fiscal deficit which led to the external current
account deficit. Since 1991 banking sector reforms have changed the business environment of
DFIs.

(iv) Flexible Mode of Fund Generation:

DFIs access to short term sources of funds is quite limited. It is notable that Term deposits,
certificates of deposits, term money borrowing inter-corporate deposits and commercial papers
all put together are equivalent to their Net Owned Fund. Thus, it is inflexible as well as
expensive for DFIs to generate fund in present scenario.

(v) Competitive Environment:

As part of banking reforms, bank was given considerable freedom to extend term loans, project
finance etc. Earlier, it was exclusive domain of DFIs. Thus, DFIs are facing stiff competition
from bank in disbursement of term capital.

(vi) Adverse Liquidity Position:

The merger in the 1990s of many domestic firms for improving competitiveness and introducing
new technologies had also an impact on DFIs adversely, since some of the older firms that could
not compete effectively could not stay in the market. Therefore they could not repay their dues
on schedule, placing enormous pressure on the DFIs liquidity position.

(vii) Stringent Prudential Norm:

The severe strain on the financial position of the DFIs increased when the institutions were
brought under the purview of regulation and supervision of the RBI. The regulation and
supervision required the DFIs to comply with internationally recognized stringent prudential
norms relating to asset classification, capital adequacy, provisioning and income recognition and
standards relating to risk management of their portfolios and market exposures.

(viii) Discriminatory Government Support System:

Due to change in Government policy- there was adverse impact on the performance of DFIs. The
NABARD, SIDBI and NHB continued to receive governmental support even after the shift in the
policy regime. Remaining DFIs are not under the list of discriminatory government support.
Inspite of above problems, DFIs in general undertook a number of measures to reposition and
reorient their operations as warranted by the competitive environment. Accordingly, a number of
innovative non-traditional products and services were offered, viz., investment banking, stock
broking, custodial services, technical advice, etc. with a view to reduce the risks by exploiting
the economies of scale. They also established management teams to handle finances, market
products, and reduce delays in decision-making, even though such initiatives entailed additional
costs.

Development Financial Institutions (DFIs) in India – List of Major Development Financial

Institutions in India
Nature and functions of major developmental financial institutions are given below:
Development Financial Institution # 1. Industrial Finance Corporation of India (IFCI
Ltd.):
It is India’s first development finance institution, was set up in 1948 on July 1 under the
Industrial Finance Corporation Act, 1948 as a statutory corporation to pioneer industrial credit to
medium and large scale industries. The constitution of IFCI was changed in May 1993 from a
statutory corporation to a company under the Companies Act, 1956 providing the institutions
with greater flexibility to respond to the needs of the rapidly changing financial system as also
greater access to the capital markets.
The operations of IFCI’s comprise project finance, financial services and corporate advisory
services. It is providing long-term financial support to all the segments of the Indian industry,
export promotion, import substitution, entrepreneurship development, pollution control, energy
conservation and generation of both direct and indirect employment. It provides custodial and
investor services, rating and venture capital services through its subsidiaries/ associate
companies.
Development Financial Institution # 2. Industrial Credit and Investment Corporation
(ICICI):
It was established in 1955. It facilitated industrial development in line with economic objectives
of the time. It evolved several new products to meet the changing needs of the corporate sector.
It provided a range of wholesale banking products and services, including project finance,
corporate finance, hybrid financial structures, syndication services, treasury-based financial
solutions, cash flow based financial products, lease financing, equity financing, risk management
tools as well as advisory services.
It also played a facilitating role in consolidation in various sectors of the Indian industry by
funding mergers and acquisitions. In the context of the emerging competitive scenario in the
financial sector ICICI Ltd. had been integrated into a single full-service banking company as
ICICI Bank in May 2002.

Development Financial Institution # 3. Industrial Development Bank of India (IDBI):

It was established on 1st July, 1964 under an act of Parliament as a wholly owned subsidiary of
the Reserve Bank of India. In February 1976, its ownership was transferred to the Government of
India and it was made as the principal financial institutions for coordinating the activities of
institutions engaged in financing, promoting and developing industries in the country. Current
shareholding of the Government of India is 58.47%.
Due to change in operating environment, Government of India decided to transform IDBI into a
commercial bank. The IDBI (Transfer of Undertaking and Repeal) Act, 2003 was consequently
enacted by Parliament in December 2003. The Act provides for repeal of IDBI Act,
corporatisation of IDBI and transformation into a commercial bank.
The provisions of the Act have come into force from 2nd July, 2004 in terms of a Government
Notification to this effect. The IDBI has already commenced banking business in accordance
with the provisions of the new Act in addition to the business being transacted under IDBI Act,
1964.

Development Financial Institution # 4. Industrial Investment Bank of India Ltd. (IIBI):

It was set up in 1971 for rehabilitation of sick industrial companies. It was again reconstituted as
industrial reconstruction bank of India in 1985 under the IRBI Act, 1984. With a view to
converting the institutions, IRBI was incorporated under the Companies Act, 1956, as Industrial
Investment Bank of India Ltd. (IIBI) in March 1997.
It offers a wide range of products and services, including term loan assistance for project finance,
short duration non-project backed financing, working capital/other short term loans to com-
panies, equity subscription, asset credit, equipment finance and investment in capital market and
money market instrument.

Development Financial Institution # 5. Infrastructure Development Finance Company Ltd.

(IDFC):
It was incorporated in 1997. It was conceived as specialized institutions to facilitate the flow of
private finance to commercially viable infrastructure projects through innovative products and
processes. Telecom, power, roads, ports, railways, urban structure together with food and
agriculture-related infrastructure.
Besides, it assists the development of urban water and sanitation sectors. It has also taken new
initiatives in the areas of tourism, health care and education. It provides assistance by way of
debt and equity support, mezzanine structures and advisory services. It encourages banks to
participate in infrastructure projects through take-out financing for a specific term and at a pre-
ferred risk profile.

Development Financial Institutions (DFIs) in India – Problems of Development Financial

Institutions in India
Due to changed environment since 1991, the Development Financial Institutions (DFIs) were
forced to reorient their lending strategies and activities towards realization of commercial
viability and competitive efficiency.

Some of the major problems faced by DFIs in post reforms era are given below:
(i) Deregulated Market Environment:
Before the 1991 DFIs were operating in a protected market with the administered rate of interest
on their loans, but after 1991, they have been forced to enter into the deregulated market
environment. Now Market related rate of interest is the operational base for the DFIs.

(ii) Crisis of Creditability:

The DFIs is facing the crisis of creditability in the wake of economic liberalisation, globalization
and changing business environment. The NPA of these DFIs is increasing and is adversely
affecting their profitability.

(iii) Growing Competition in Financial Market:

The free market economy during the 1990’s also witnessed the keen competition for DFIs from
the commercial banks, NBFCs and others. At present, the commercial banks are financing both
short- term and long-term finance to the corporate sector so it has created a problem for the DFIs
to increase and diversify their client base.

(iv) Easy Access to Capital Market:

The liberalisation and globalization process started in the Indian economy has revived the capital
market and opened the door for the corporate sector to raise their resources directly from the
market. The corporate sector is not interested in the financial assistance of DFIs.

(v) Competitive Interest Rates:

The DFIs have already entered into the capital market to raise their resources. These resources
are generally raised with the market rate of interest that is higher than the previously
administered rate of interest, so it results in an increase of their cost of borrowings. The DFIs are
also being forced to reduce their lending rates due to competition.

(vi) Accountability to Stakeholders:

The increasing access of the DFIs to the Indian capital market has created a new type of problem
for them with which they were not acquainted earlier. Thus, the management of most of the DFIs
in this competitive economy is always on their toes because of this increasing accountability
from the public and more specifically from their private shareholders. Now DFIs are required to
accountable to their stakeholders for transparency and reporting.

(vii) Universal Banking System:

The concept of universal banking, which has been recommended by the Khan Committee, has
put the DFIs into a fix. Now the concept of development banking is slowly going out of fashion.
They have now converted into an NBFC or a universal bank.
Development Financial Institutions have been assigned a crucial role in the development of the
country. They have played their role in the promotion of industrial units and entrepreneurial
environment. However, due to change in economic environment since 1991 continuous dilution
is occurred in their working. New economic policy of the government since 1991 has made some
of the development financial institutions irrelevant in the present context of development.
Structural changes have been made in the role and objectives of some of the development
financial institutions. Even today some of the financial institutions are still playing their role in
proper perspective.