Financial Institutions/NBFCs
- Credit Rating Agency in India
- Rating Methodology
- Financial Institutions/NBFCs
Non-Banking Finance Companies (NBFCs)/Housing Finance Companies (HFC’s) play an important role in the Indian financial market. National Housing Bank regulates HFC’s and Reserve Bank of India (RBI) regulates both NBFCs and banks, there are some significant differences in the regulatory treatment, with NBFCs/HFC’s being given greater flexibility in governance structure and operational matters, and being allowed to lend independent of priority-sector targets and of statutory reserve requirements. However, at the same time, there are regulatory restrictions on the bouquet of services that NBFCs/HFC’s can offer and on their funding options. Normally NBFCs/HFC’s lend for housing loans, vehicle loans, personal loans, loan against property/shares, corporate loan, builder loans etc. The rating methodologies developed by Infomerics for evaluation of Financial Institutions & NBFCs/HFC’s comprise of qualitative and quantitative factors, the details of which are described below:
The Qualitative Factors that are found critical in the rating process are:
The scale of operations of an NBFC/HFC, portfolio of products offered and distribution network determines its capacity & ability to grow, while maintaining reasonable risk adjusted returns and sustenance of earnings with resilience. Hence, the strength of a NBFC/HFC in terms of scale of operations and market presence are evaluated.
Ownership structure could have a key influence on an NBFC’s/HFC’s credit profile. Strong promoter and strategic fit with the parent can benefit an NBFC’s business growth, earning, liquidity and capitalisation, and hence its credit profile. In assessing an NBFC’s/HFC’s ownership structure, the parameters examined include, among others: the credit profile of the promoter, shareholding pattern of the NBFC/HFC, operational synergies of the NBFC/HFC with its promoter, and track record of the promoter in providing support.
Quality of management, systems and policies are the foundation stones on which an NBFC’s/HFC’s credit risk profile is built. The importance of these factors is even higher for a new NBFC/HFC, one with a shorter track record, or one with a changing business profile. The composition of the board, frequency of change of CEO and the organisational structure of the company are examined. The company's strategic objectives and initiatives in the context of resources available, its ability to identify opportunities and track record in managing stress situations are taken as positives. The extent of digitisation of the operations and adequacy of the information systems used by the management are evaluated.
A careful evaluation of the risk management policies of the NBFC/HFC is done as that provides important guidance for assessing the impact of stress events on the liquidity, profitability, and capitalisation of the company concerned. The process of risk profiling also involves evaluating the NBFC’s/HFC’s overall portfolio characteristics, besides its recovery and monitoring systems. The NBFC's/HFC’s balance sheet is also examined from the perspective of interest rate sensitivity.
The track record of the company in complying with regulatory requirements of RBI/NHB are examined
Consistent and fair accounting policies are a prerequisite for financial evaluation and peer group comparisons. By virtue of being incorporated under the Companies Act, NBFCs/HFC’s are required to follow the Accounting Standards prescribed by the Institute of Chartered Accountants of India. Further, the RBI/NHB have also issued prudential norms for NBFCs/HFC’s, specifying the accounting methods to be used for income recognition, asset classification, provisioning for bad and doubtful advances and capital adequacy. In evaluating an NBFC’s/HFC’s accounting quality, the review is made with regard to the company’s accounting policies, notes to the accounts, and auditors’ comments in detail. Deviations from the Generally Accepted Accounting Practices are noted and the financial statements of the NBFC/HFC are generally adjusted to reflect the impact of such deviations.
The operating environment has a significant bearing on an NBFC’s/HFC’s credit rating as it can impact its growth prospects and asset quality quite considerably. In assessing the operating environment, Infomerics looks at the overall economic conditions, prospects of the industry related to the asset class being financed, and the regulatory environment. For instance, in the case of a commercial vehicle (CV) financing NBFC, the level of economic activity and freight rates are very important, just as the outlook on real estate is important for a home finance company, from the perspective of both asset creation and asset quality. For an NBFC, regulatory changes can significantly impact (either positively or negatively) credit losses. For instance, the establishment of the credit information bureau has helped lenders take informed credit decisions, while The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI) has helped them recover real estate backed loans more efficiently.
The Quantitative Factors as enumerated below cover a detailed review of key financial performance parameters and stability
Capital Adequacy is a measure of the NBFC’s/HFC’s ability to meet its obligations relative to its exposure to risk and also relates to the degree to which the NBFC’s/HFC’s capital is available to absorb possible losses. It also indicates the ability of the NBFC/HFC to undertake additional business. Riskiness of the product and granularlity of the portfolio are factors that have a significant bearing on the amount of capital required to provide the desired degree of protection to an NBFC’s/HFC’s debt holders. The evaluation by Infomerics factors the conformity of the NBFC/HFC to the regulatory guidelines on capital adequacy ratio. Higher proportion of Tier I (core capital) in the overall capital is viewed favorably. The expected growth in the asset base and ability of the NBFC/HFC to generate capital through profits or by accessing capital markets, is also evaluated.
Resource base of the NBFC/HFC is analysed in terms of cost and composition. Proportion of deposits /loans/bonds in funding mix is examined. Deposit growth rates and their rollover rates are also analysed. Ability of the NBFC/HFC to raise additional resources at competitive rates is also examined.
Asset quality plays an important role in indicating the future financial performance of an NBFC/HFC. Asset quality holds the potential to affect earnings (higher NPAs could dilute the yields and necessitate higher credit provisions) and capital (lower earnings could slow down the internal capital generation or in extreme situations (loss) could weaken the capital).The evaluation of asset quality begins with the examination of the NBFC’s/HFC’s credit risk management framework. Assessment is also made of credit risk concentration, trend in delinquencies, Gross NPA percentage, Net NPA percentage, and Net NPAs in relation to Net Worth. The NBFC's/HFC’s experience of loan losses and write off/provisions are studied carefully. The portfolio diversification and exposure to troubled industries/areas is evaluated to arrive at the level of weak assets. In assessing diversification, the common factors include loan mix, portfolio granularity, geographical diversification and borrower profile. Restructured assets, if any, are closely examined to arrive at the potential NPAs.
It is important for an NBFC/HFC to maintain a favourable liquidity profile for the smooth functioning of its funding activity (fresh asset creation) and to honour its debt commitments in a timely manner. It is also important that an NBFC/HFC manages its interest rate risk, as the same could impact its future profitability. In assessing an NBFC’s/HFC’s liquidity profile, the evaluation is done on the company’s policy on liquidity, the maturity profiles of its assets and liabilities, the asset-liability maturity gaps, and the backups available to plug such gaps. The evaluation also focuses on the diversity of the NBFC’s/HFC’s funding sources and their quality (i.e. availability of these sources in a stress situation). The short term external funding sources in the form of unutilized lines of credit available from banks, etc along with directed and other investments if any are important sources of reserve liquidity. and available cash balances, if any, are considered as important sources for liquidity comfort. The liquidity comfort shall also be taken from available cash flow adequacy, any immediate equity infusion, etc. A separate section of Liquidity is made in the Press Release highlighting therein the bucket-wise asset-liability maturity profile and a synopsis of the aforesaid liquidity support to meet the near-term debt servicing obligations.
The purpose of the evaluation here is to assess the level of future earnings and the quality of earnings of the NBFC concerned, which is done by looking closely at the interest spreads, non-interest income, operating expenses, and credit costs. Business areas that contributes to the core earnings is evaluated for risks as well as for its earning prospects and growth rate. The ability of the NBFC/HFC to complement its interest income with other income is also assessed. Substantial non-interest income allows greater diversification, which in turn can improve the resilience of earnings, thereby improving an NBFC’s/HFC’s risk profile. After assessing the income stream, the evaluation is done on the NBFC’s/HFC’s operating efficiency (operating expenses in relation to total assets, and cost to income ratio) and compares the same with that of its peers. Finally, the credit costs are also carefully looked into. Importantly, a very high return on equity may not necessarily translate into a high credit rating, given that the underlying risk could be very high as well, and being so it could be more volatile or difficult to predict.
CONCLUSION
Detailed peer analysis is done to determine the relative strengths and weaknesses of the NBFC/HFC in its present operating environment and any impact on it, in future. The rating process ultimately determines the likelihood of the rated debt obligation being repaid in full and on time. All relevant quantitative and qualitative factors are considered together, as relative weakness in one area may be more than adequately compensated for by strengths elsewhere. However, the importance assigned to the factors are different for short term ratings and long term ratings. The intention of long term ratings is to look over a business cycle and not adjust ratings frequently for what appear to be short term performance aberrations. The final rating decision is made by the Rating Committee after a thorough analysis of the NBFC’s/HFC’s position over the term of the instrument with regard to business fundamentals. The final rating decision is made by the Rating Committee after a thorough analysis of the NBFC's/HFC’s position over the term of the instrument with regard to business fundamentals.
FINANCIAL & OPERATING RATIOS
In order to evaluate the aforesaid quantitative factors, various financial & operating ratios are calculated to see how a particular NBFC/HFC and/or FI is placed over a time horizon of three-five years on a standalone basis as also with reference to its peers:
GROWTH
PROFITABILITY
GEARING
ASSET QUALITY
In order to assess the performance of an NBFC/HFC with respect to its growth trend, we look at Total Income, PBT & PAT, Total Assets, and Tangible Networth. While the level of business, as reflected in terms of Total Assets, indicates the ability of an NBFC/HFC to generate revenue, these are not exhaustive by themselves. This is so because proper deployment of assets also play an important role in enhancing the total income. While, to an extent, the profit trend is the fallout of trend in revenue, the ability of the entity to contain its overhead & establishment expenses and to source and deploy the funds go a long way in driving the profit. The ultimate success of an NBFC/HFC in terms of adequacy of cash flow, long-term sustainability and ability to absorb shocks in case of adversities depends upon its ability to generate decent level of profit on continuous basis. Although the usual profitability parameters like PBT Margin and PAT Margin indicate a direction, many other profitability related ratios are assessed. For an asset-financing and lending NBFC/HFC, the usual activity centres around competitive sourcing of funds and effective & gainful deployment of the same. In that context, it is important to ascertain the overall borrowing cost and the overall yield, the difference of which indicate the Interest Spread. But to evaluate the net interest earning on assets which are deriving such income, Net Interest Margin is considered as one of the most important parameters. Various other parameters are also calculated to ascertain the overall return with reference to total assets and networth. Interest coverage implies the interest servicing ability of the NBFC/HFC.
As for assessing the soundness of capital structure and the leverage position of an NBFC/HFC, more than the traditional gearing ratio, the Capital Adequacy is looked at to measure the adequacy of capital vis-a-vis its risk weighted assets. The minimum Capital Adequacy ratio is stipulated by Reserve Bank of India/N.H.B. Higher proportion of Tier I (core capital) in the overall capital is viewed favorably. Generally for NBFCs/HFCs, the overall gearing ratio is higher vis-a-vis that of manufacturing companies in view of their business centering around funds.
The asset quality of an entity (which is predominantly engaged in lending and/or asset financing activities) is a very critical performance parameter. These are measured as a proportion of gross NPAs to gross advances and net NPAs to net advances. While gross NPA percentage indicates the true picture of asset quality, the net NPA percentage is calculated after factoring the provision made for NPAs. However, the Net NPAs to Networth signifies the ability of the company to absorb the impact of NPAs after provisions, while Provision Coverage indicates the extent of provisions made in respect of Gross NPAs.
Updated on July 07, 2025