Financial Institutions

www.fitchratings.com 27 February 2012

Financial Services / India




2012 Outlook: Major Indian Non-Bank Finance Companies
Stable Now but Bumpy Road Ahead
Outlook Report

Rating Outlook
Stable, But Cautious Outlook: Fitch Ratings maintains a stable but cautious outlook on the
major Indian non-bank finance companies (NBFCs) sector for 2012. The impact of a cyclical
increase in delinquencies and a drop in loan growth could be absorbed by high pre-provision
profits, and capital buffers are adequate at most of the nine major NBFCs (large commercial
finance companies) covered in this report. However, regulatory changes could increase the
costs of raising fresh capital and funding, and sharply reduce profitability in the medium term.
Asset Quality Deterioration Expected: The cyclical headwinds from a moderating economy
are affecting the NBFCs' asset quality, and loan growth will slow down in 2012. Fitch expects
"reported" non-performing loan (NPL 180 days overdue) ratios at the nine NBFCs of 2.5%-
3.0% in 2012 (2.1% for the financial year to end-March 2011 (FY11)). Delinquencies are
increasing in key business lines, but unless this is accompanied by a sharp erosion of collateral
values, the high risk-adjusted margins should be able to absorb the jump in credit costs.
Regulatory Changes: The Reserve Bank of India (RBI) has introduced guidelines under which
bank loans to NBFCs are not considered priority-sector loans from 1 April 2011, which reduces
incentives for banks to lend directly to NBFCs and will increase the latter's funding costs.
Further, proposed regulatory changes include revising the NPL definition to 90 days overdue,
setting a minimum Tier 1 ratio of 12% and introducing a liquidity ratio requirement. The RBI may
also propose similar measures for bilateral securitisations for NBFCs to those proposed for banks.
These proposed and potential changes could weaken the NBFCs' profitability and affect access
to fresh capital and funding.
Funding Access Could Worsen: The large dependence on institutional/wholesale funding is
an industry-wide issue. While the proportion of short-term borrowings in FY11 was lower at
most companies (compared with FY08), the regulatory changes could adversely affect funding
from banks, which represents the NBFCs' largest source of funding. Although some of the
larger NBFCs have attracted investments from domestic and international institutional investors,
gaining access to alternate long-term debt funding is a broad industry-wide challenge.
Profitability Under Pressure: Despite the likely downward shift in interest rates in 2012,
funding costs for NBFCs may increase in the year, which, together with higher credit costs, will
reduce profitability. Fitch expects the weighted average return on assets (ROA) of the nine
NBFCs to range from 1.5% to 2% in 2012 (H1FY12: 2.6%; FY11: 2.9%), from shrinking net
interest margins (NIMs), low loan growth and high credit costs.
What Could Change the Outlook
Access to Funding: Access to stable funding from banks, institutional investors and capital
markets is a key factor in the stable outlook on the sector, and any disruption in funding access
could lead to negative rating action. A large deterioration in asset quality, profitability and
capital levels could also result in negative rating action.
NBFCs on Negative Outlook: An inability to raise timely equity, funding constraints or a greater-
than-expected rise in credit costs could lead to a downgrade of NBFCs on Negative Outlook.
Severe Economic Slowdown: A continued decline in economic growth in 2012 in particular,
a steep drop in industrial output, affecting asset quality/asset growth and earnings could also
lead to negative rating action.
Rating Outlook
S S T T A A B B L L E E
Figure 1
0
20
40
60
80
100
Positive Stable Negative
Rating Outlooks
(Major Indian NBFCs)
(%)
Source: Fitch

Related Research
Other Outlooks
www.fitchratings.com/outlooks

Analysts
Ehsan Syed
+91 22 4000 1722
ehsan.syed@fitchratings.com

Ananda Bhoumik
+91 22 4000 1720
ananda.bhoumik@fitchratings.com

Prakash Agarwal
+91 22 4000 1753
prakash.agarwal@fitchratings.com
Financial Institutions



2012 Outlook: Major Indian Non-Bank Finance Companies
February 2012
2

Key Issues
Outlook for Key Asset Classes
HMCVs and CEs Will be Hurt the Most
Fitch expects heavy and medium commercial vehicle (HMCV) financing to remain weak in
2012. The agency's analysis of the correlation between the index of industrial production (IIP)
and new HMCV sales for the last five years (January 2007-November 2011) shows a positive
correlation of 0.63 (which increases to 0.72 in the last one year (December 2010-November
2011). Historically, IIP has shown a negative correlation with the RBI's policy lending rates
(repo rates), and the agency's study also shows a negative correlation of 0.59 between IIP and
repo rates in the latest year. With interest rates at a high level (the RBI's repo rate is currently
8.5%), new HMCV sales will remain subdued in 2012.
90%-95% of HMCVs in India are financed, and this is a key business line for most of the
NBFCs. Although the interest rate cycle could be peaking and the RBI may start reducing
interest rates in the coming months (it cut the cash reserve ratio of banks by 50bp to 5.50% on
24 January 2012), there will be a lag of several months between the cuts in interest rates and a
stable/sustained increase in IIP and HMCV sales/financing.
The financing of used HMCVs is less affected by economic slowdown. However, interest rates,
fuel prices and freight rates have a larger impact on the outlook of aspiring individual drivers
(looking to own vehicles) and small road transport operators, who are the main buyers of used
HMCVs. Demand for used HMCV financing will also thus remain weak in 2012 in view of the
tough operating environment.
High interest rates, and the lower increase in freight rates over the last three years (than in
diesel prices), are also increasing stresses on the HMCV operators' cash flows. This will lead to
increased delinquencies in 2012, in particular for the less seasoned HMCV loans. Asset quality
will therefore also come under pressure in the HMCV segment in 2012, at the same time as
credit growth in this business line slows down.
Financing for construction equipment (CE) will remain weak in 2012, in view of the delays/
slowdowns in infrastructure projects and ban on mining in some regions. Due to the specialised
nature of much of the equipment and the limitations on its use in other fields, delays or closure
of a project can hit the cash flows of the owners. Fitch expects delinquencies to increase and
asset quality to come under pressure in this asset class.
Figure 2

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IIP (LHS) Repo rate (RHS)
(%)
Index of Industrial Production (IIP) and Repo Rate
Jan 2007 to Nov 2011
Repo rate as at end of each month
Source: RBI







Related Criteria
Finance and Leasing Companies Criteria
(December 2011)
Financial Institutions



2012 Outlook: Major Indian Non-Bank Finance Companies
February 2012
3

Figure 3
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HMCV dom. mthly. sales volumes (LHS) IIP (RHS)
(IIP)
Index of Industrial Production (IIP) and HMCV Sales
Jan 2007 to Nov 2011
Source: Society of Indian Automotive Manufacturers, Bloomberg, RBI


Property and Small Business Loans Remain a Concern
Fitch remains concerned about the expansion into new, higher-risk business lines, such as
loans against property (LAP) and small business loans (SBL) at some of the major NBFCs, and
in the broad NBFC sector in India. Besides the rapid growth and low seasoning, the collateral
backing these loans (in most cases) comprises non-productive real estate assets, and some of
the SBLs are unsecured. Fitch expects these asset classes also to come under stress in 2012.
Light Commercial Vehicle and Agricultural Equipment to Remain Stable
Fitch expects the financing of light commercial vehicles (LCVs) to remain largely stable in 2012.
The agency's analysis shows a constantly decreasing positive correlation between LCV sales
and IIP (0.86 in the last five years, 0.65 in the last two years and 0.28 in the last one year),
reflecting an increasing disconnect between sales of LCVs and industrial activity. This stems
from the use of LCVs for last-mile, short-distance transportation, which is influenced less by the
industrial slowdown, and more by non-discretionary consumption activities.
Due to the above-average monsoon rainfall in 2011 in most parts of the country and continued
government initiatives for rural development (through various rural development programmes),
Fitch expects the sales and financing of agriculture equipment to remain stable in 2012.
Overall Asset Quality Under Pressure
Fitch has noticed a significant increase in 90-day delinquencies in the 2010 and 2011 vintages
at some NBFCs (relative to 2008 and 2009 vintages), which indicates an increasing rate of
defaults and points to pressures on asset quality. While expected lower credit growth would
partially address the issue of asset quality, it could also make result in asset quality issues as a
result of the lower denominator effect.
Fitch's study of trends in credit growth, "reported" weighted gross NPL ratios and one-year lag
NPL ratios of the nine NBFCs from FY07-H1FY12 shows that reported NPLs peaked in FY09,
when credit growth was lowest, while one-year lag NPLs peaked in FY10. The reported NPL
and one-year lag NPL ratios both bottomed in H1FY12, when loan growth was at its highest.
The reported gross NPL ratio is understated due to a 180-day delinquent norm for Indian
NBFCs, as against a 90-day norm for banks. The denominator effect (with aggressive loan
book growth in the last two to three years) also mutes the reported NPL ratio.
With a tough operating environment around the key HMCV segment and pressures on some
other segments also, the loan growth of the sector will moderate in 2012. The agency expects
the gross NPL ratio of the nine major NBFCs to rise and range between 2.5% and 3.0% in
2012 (2.08% in FY11). However, even with a 73% provision coverage ratio (PCR; 73% in
FY11) in 2012, the incremental credit costs can be well absorbed by the pre-provision profit.
This reflects the low operating cost base and high risk-adjusted margins of the NBFCs.

Financial Institutions



2012 Outlook: Major Indian Non-Bank Finance Companies
February 2012
4

Figure 4
0
2
4
6
8
FY07 FY08 FY09 FY10 FY11
NBFC Credit costs/avg loans NBFC PPOP/avg. loans
Banks Credit costs/avg loans Banks PPOP/avg. loans
NBFCs' and Banks' Pre-Provision Profitability and Credit Costs
(%)
Source: NBFC aggregate data, Fitch, RBI


Figure 5
0
1
2
3
4
FY08 FY09 FY10 FY11 H1FY12
0
10
20
30
40
50
60
1 year lag NPL ratio (LHS) Gross NPL ratio (LHS) Credit growth (RHS)
NBFCs' Credit Growth and NPL Ratios
H1FY12 annualised.
b
NPLs/previous-period loans
Source: Source: Aggregate NBFC data, Fitch
(%)
b


Figure 6
0.5
1.5
2.5
3.5
FY07 FY08 FY09 FY10 FY11 H1FY12
NBFC ROA Banks ROA
(%)
NBFCs' and Banks' Returns on Assets
H1FY12 annualised
Source: Aggregate NBFC data, Fitch, RBI.
(%)



















Financial Institutions



2012 Outlook: Major Indian Non-Bank Finance Companies
February 2012
5

Figure 7
0.0
5.0
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15.0
20.0
25.0
FY07 FY08 FY09 FY10 FY11 H1FY12
NBFC ROE Banks ROE
(%)
NBFCs' and Banks' Returns on Equity
H1FY12 annualised
Source: Aggregate NBFC data, Fitch, RBI.
(%)


High Dependence on Institutional/Wholesale Funding
The high dependence of NBFCs on bank funding (over 60% of total debt in FY11) is a major
sector-wide structural weakness. The significant 55% growth in bank credit to the broad NBFC
sector in FY11 (compared with 23% overall credit growth) and the RBI's subsequent revised
guidelines, under which bank loans to NBFCs are not classified as priority-sector loans from 1
April 2011, reduce the banks' motivation for fresh direct lending to NBFCs. Together with other
proposed and potential regulatory changes, this may reduce their appetite for lending to NBFCs.
It is pertinent to note that NBFCs` bank borrowings in FY11 were considerably higher than in
FY08, while the proportion of debentures has more than halved, so finding alternate long-term
debt funding is an industry-wide challenge in the medium term.
Funding Costs will Increase
Fitch expects the increases in funding costs to continue in the medium term, as a result of the
regulatory changes (see Regulatory Changes). The NBFCs' focus on the higher-risk customer
segment has been reflected in high NIMs (average 6.5% at the nine NBFCs, against around
3% at the banks). However, Fitch expects the spike in funding costs from the exclusion of bank
lending to NBFCs from the priority-sector lending category of banks to shrink NIMs in 2012.
Furthermore, the limitations on the NBFCs' ability to pass on increasing funding costs to a
relatively weak borrower segment (the bulk of their customers are higher risk, with limited
access to banking services) increase funding costs across the industry. Fitch estimates the
incremental funding costs to vary from 50-200bp for the nine major NBFCs.
Figure 8
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FY07 FY08 FY09 FY10 FY11
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Tier 1 ratio (LHS) Equity/assets ratio (LHS) Net NPL/equity ratio (RHS)
(%)
NBFCs' Capital Ratios and Unreserved NPLs to Equity
Source: Aggregate NBFC data, Fitch
(%)










Financial Institutions



2012 Outlook: Major Indian Non-Bank Finance Companies
February 2012
6

Figure 9 Figure 10
Deposits
3.4% Hybrids
0.3%
Working
capital
loans
17.2%
Term
loans
46.1%
Sub debt
5.3%
NBFCs' Funding Profile
(End-March 2011)
Source: NBFC Aggregate data, Fitch
Debentures/NCDs
18.2%
Other loans
0.9%
Commercial paper
8.6%

Deposits
3.4%
Term
Loans
25.9%
Working
capital
loans
14.2%
Sub debt
4.2%
NBFCs' Funding Profile
(End-March 2008)
Source: NBFC Aggregate data, Fitch
Commercial paper
5.8%
Other loans
3.9%
Debentures/
NCDs
43.6%


Regulatory Changes
Fitch believes the changing regulatory landscape will have a significant impact on the operating
environment of the NBFC sector in the medium term, even though the impact may be limited in
2012. The high profitability and credit growth that the sector has enjoyed so far will moderate
as a result of increases in funding costs and credit costs, and a drop in leverage.
Loans to NBFCs not Eligible as Priority-Sector Loans of Banks
Implementation of the revised regulatory guidelines on priority-sector lending issued by the RBI
in May 2011, under which bank loans to NBFCs (except eligible NBFC-micro finance institution
loans) are not eligible for the banks' priority-sector loan targets from 1 April 2011, adversely
affects a major source of direct loans for NBFCs.
The "Report of the Nair Committee on Priority Sector Lending" made public by the RBI on 21
February 2012 recommends that loans to non-bank financial intermediaries for on-lending to
specified segments be classified as a priority sector, up to a maximum of 5% of adjusted net
bank credit or credit equivalent of off-balance-sheet exposures (whichever is higher), subject to
restrictions/conditions. The conditions include: the NBFC should be registered and should have
at least 65% of its assets under management on its balance sheet; the interest spread on on-
lending will be capped at 6%; only incremental priority-sector loans by NBFCs will be eligible;
and 15% of the accounts have to be verified by the banks' officers themselves. If and when
these recommendations are implemented, it would partially lessen the impact of the guidelines
implemented in April 2011, though it remains to be seen whether RBI will amend/rescind these.
NBFCs can still borrow from banks on usual commercial terms and may also be able to find
many banks, especially private-sector and foreign banks, as ready buyers for the pass-through
certificate (PTC) securitisation of their loans to the priority sectors. However, the increase in
funding costs from PTC securitisation, including the impact on capitalisation from the deduction
of credit enhancements provided, could discourage NBFCs from using this channel extensively.
Expected Changes in Bilateral Securitisations
Fitch believes the restrictions on providing credit enhancement in bilateral securitisations (as
proposed for the banks in the updated draft guidelines on securitisation issued by the RBI in
September 2011) could remove another key channel of funding for the NBFCs, or make
funding through this route very expensive for NBFCs, if the RBI prescribes a similarly strict
stance on credit enhancement in bilateral securitisations by NBFCs. Most of the NBFCs
received a premium on bilateral securitisations, as buying the loans from NBFCs (most of these
loans met the banks' priority-sector lending criteria) helped the banks meet their priority-sector
lending targets. While the practice of booking this income upfront or amortising it over the life of
the assets varies across the industry, this source of income could disappear and reduce
profitability sharply for some players, especially the firms that have been very active in bilateral
securitisations, such as Shriram Transport Finance Co. Ltd. ('Fitch AA(ind)'/Stable) and
Mahindra & Mahindra Financial Services Limited ('Fitch AA+(ind)'/Stable).
Financial Institutions



2012 Outlook: Major Indian Non-Bank Finance Companies
February 2012
7

Report of the Working Group on the Issues and Concerns in the NBFC Sector
The recommendations of the "Report of the Working Group on the Issues and Concerns in the
NBFC Sector" (also called the Usha Thorat Committee, as the working group was chaired by
Ms Usha Thorat, a former RBI deputy governor), made public by the RBI in August 2011 and
open for public comments until 30 September 2011, could have a significant impact on the
NBFCs' profitability, and thereby their access to fresh capital and funding. Fitch expects most
of these guidelines to be implemented, with a little bit of modification in some clauses. The
agency nevertheless considers positively the improving supervisory framework and regulatory
tightening of the NBFC sector.
The report's main recommendations are listed below:
1. The Tier 1 ratio of registered NBFCs should be increased to 12%, and three years should
be given to achieve the required ratio (currently the minimum Tier 1 ratio is 7.5%).
2. Asset classification and provisioning norms similar to those for banks are to be introduced
in a phased manner (this includes the 90 days overdue norm for classifying NPLs, from
the current 180 days past due norm for NBFCs).
3. Liquidity ratios may be introduced for all registered NBFCs, such that cash, bank balances
and government securities fully cover the gaps, if any, between cumulative outflows and
cumulative inflows for the first 30 days (currently only deposit-taking NBFCs are required
to hold 15% of their public deposits in RBI-defined liquid assets).
4. The Securitisation and Reconstruction of Financial Assets and Enforcement of Security
Interest Act 2002 (SARFAESI) may be extended to NBFCs (currently NBFCs cannot
enforce their claims on defaulters under SARFAESI).
5. Higher disclosures have been suggested by the RBI. These cover provision coverage
ratios, liquidity ratios, asset liability profiles, the extent of financing of a parent company's
products and the movement of non-performing assets.
6. Capital market and real estate exposures. Risk weights will be increased to 125% for
capital market exposures and 150% for commercial real estate exposures (from the
current 100% for both these categories).
Impact of Regulatory Changes on the Overall NBFC Sector in India
Fitch believes the changing regulatory landscape will have a significant impact on the broad
Indian NBFC sector, and could lead to consolidation in the small and mid-sized segments in the
medium term. Based on RBI data, as at 30 June 2011, there were 12,409 registered NBFCs,
which are classified by the central bank according to the kind of liabilities they access (deposit-
taking or non-deposit-taking), the type of activities they pursue (six categories, including asset
financing companies, loan companies etc) and according to systemic importance ("systemically
important" or otherwise).
The majority of the non-deposit-taking NBFCs are small in size and regulatory supervision
becomes heavier only when their asset size exceeds INR1bn (at that threshold these are
defined as "systemically important" by the RBI). There is very little financial information
available in the public domain on the non-deposit-taking NBFCs that are not large enough to be
classified as "systemically important".
However, based on the agency's analysis of a sample of small registered NBFCs, the
dependence on bank funding has been significant and these companies will be affected most
by the exclusion of bank loans to NBFCs from the priority sector category from 1 April 2011.
Fitch estimates that funding costs will rise by around 200-300bp for the smaller NBFCs, and
availability of credit from the banking sector could also reduce gradually, although so far the
impact remains unclear.
Financial Institutions



2012 Outlook: Major Indian Non-Bank Finance Companies
February 2012
8

As regards the larger NBFCs deposit-taking (297 companies at end-March 2011) and the
"systemically important" non-deposit-taking NBFCs (in the latter category, out of 253
companies at end March 2011, only 149 companies used external funds/borrowings), the
agency's study of bank lending in the last 10 months and discussions with NBFCs and banks
reveal that to date there are no signs of a liquidity crunch at sector level. Banks have
nevertheless become cautious and the cost of funds for NBFCs is increasing across the board.
While the impact on some of the larger NBFCs with the most diversified funding profiles in
Fitch's rated universe of NBFCs is expected to be just around 50-100bp, the wider sector could
see a 100-200bp spike in funding costs, although the impact will vary depending on the type of
debt used by a particular NBFC. Additional risk premiums on fresh lending will be sharply
higher for both direct lending and bilateral securitisation. Nevertheless, the NBFCs' high risk-
adjusted yields should cushion the impact, and the impact on profitability manageable.
However, if the recommendations of the Usha Thorat Committee in particular, the stipulation
of a minimum net worth of INR50m and asset size of INR500m for registration of NBFCs are
implemented, the small NBFCs segment could undergo major consolidation. If the banks
expand into the rural areas to a significant degree, the larger NBFCs could see pressure on
their interest margins from increased competition, although the NBFCs' niche expertise,
especially in asset valuation, and flexible (though at times informal) evaluation methods would
continue to help them attract certain customer segments in rural/semi-urban India, that may not
be bankable for the commercial banks.
2011 Review
Credit growth was strong at most NBFCs in 2011, and high interest rates did not affect
operating performance or asset quality. The increasing leverage, larger dependence on short-
term debt and low loan book seasoning led to a Negative Outlook for three rated major NBFCs.
The overhang of impending regulatory changes and increasing interest rates, despite slowing
economic growth, emerged as the key external credit events for the NBFC sector.


Figure 11
NBFCs Covered in This Report- Ratings and Key Financial Variables
Name of the NBFC
National Long-
Term Rating Outlook
Assets
(INRm)
NPL
ratio NIM
Tier 1
ratio CAR ROAA ROAE
Shriram Transport Finance Co. Ltd. Fitch AA(ind) Stable 306,968 2.6 7.5 16.7 24.9 4.2 28.2
Mahindra & Mahindra Financial Services Limited Fitch AA+(ind) Stable 131,695 4.4 11.3 17.0 20.3 4.2 24.4
Sundaram Finance Ltd Fitch AA+(ind) Stable 121,092 0.8 6.0 12.6 16.2 2.7 20.7
Cholamandalam Investment and Finance Co. Ltd Fitch AA(ind) Stable 94,433 3.2 7.2 10.8 16.7 0.8 8.0
SREI Equipment Finance Pvt Limited Fitch AA(ind) Negative 97,105 3.3 6.5 11.0 15.8 1.6 12.6
Religare Finvest Limited Fitch AA(ind) Negative 109,824 0.1 4.3 14.9 16.2 1.4 7.5
Magma Fincorp Limited Not Rated (NR) NR 56,759 - 6.2 11.3 18.2 2.2 19.3
Shriram City Union Finance Limited Fitch AA(ind) Stable 92,769 1.9 8.4 16.4 20.8 3.1 22.1
SREI Infrastructure Finance Limited Fitch AA(ind) Negative 80,457 - 3.1 25.1 29.4 2.2 8.0
Financial data as of end-March 2011(FY11); except for assets all the financial data is in percentages
Source: Fitch
Financial Institutions



2012 Outlook: Major Indian Non-Bank Finance Companies
February 2012
9



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