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Sticking to his knitting

Ramesh Iyer is confident about sustaining growth despite an inflexible regulator thwarting their banking plans

June 26, 2013. The third day of Wimbledon and in a defeat that shakes the tennis-watching world, defending champion Roger Federer loses to world No.116 Sergiy Stakhovsky in the second round. It is the first time in a decade that Federer has not made it to the quarter-final of a Grand Slam but his replies at a post-match interview are typically insouciant. “It’s nicer to be able to leave the court quicker than go through the trophy ceremony. That’s the nice thing about today,” he says cheekily before adding more soberly that earlier losses at Wimbledon “haven’t hurt this much, that’s for sure”. 

Fast forward two months and we are at the Raja Aederi-designed Mahindra Tower in Worli, Mumbai, for a meeting with Mahindra Finance managing director, Ramesh Iyer. The Federer episode is especially fresh in our minds because the country’s biggest non-banking finance company (NBFC) by market capitalisation was one of the forerunners to get a banking licence — the defending champion, you could say — but it didn’t proceed with the application. And in spite of what is happening around, Iyer seems as surprisingly light-hearted as Federer was after his unexpected exit. The Sensex is trading down 700 points, the rupee is taking a pounding and Iyer asks casually, “Do you think the market will drop 1,000 points today?” 

Sure, his stock options are probably at risk but, unlike other finance company honchos, Iyer is buffered from the market because of his semi-urban and rural customer base. This, after all, is a two-decade-old NBFC that was formed primarily to help finance sales of M&M’s utility vehicles. Indeed, in the initial days, dealers owned a third of the firm and even sat on the board. That changed after it listed in 2006 and its growing stature over the years — and, perhaps, group chairman Anand Mahindra’s history of investing in and lending his name to an NBFC that went on to become a bank — meant most industry observers took it for granted that Mahindra Finance would convert to a bank at the first opportunity. In the last week of June 2013, though, around the time a stunned Federer was walking out from Centre Court, Iyer pulled his NBFC out of the race. 

Like Federer, Iyer, too, doesn’t have much left to prove. He and his team have grown Mahindra Finance from a small, captive financier employing 50 people to an NBFC that today has a workforce of 14,000, a market capitalisation of ₹15,000 crore and a lending book twice that. Its 2.5 million customers are spread over 170,000 villages across India and serviced through its 675 (and growing) branches. Still, the last-minute reversal took everybody by surprise. So, what changed and does the rush on the part of other NBFCs to become banks make commercial sense? 

Lemming rush

Down south, peer Sundaram Finance, has always been clear that it doesn’t want to be a bank. For the past three decades and more, managing director, TT Srinivasaraghavan, has been guided by Benjamin Franklin’s succinct, four-word counsel — “When in doubt, don’t”— and he’s stuck to that, despite being criticised for being overly conservative. “We did analyse the prospects of becoming a bank but did not find one compelling reason that jumped out of the page and said, ‘Here is why you should’,” says Srinivasaraghavan. “When what you are doing is going well and you are doing it well, why would you want to mess with that?”

Another NBFC heavyweight, Shriram Group, too, is reported to be weighing its options in case the Reserve Bank of India (RBI) does not let group company Shriram Transport Finance function as a separate entity. Why did Shriram Capital apply for a licence at all? Group director GS Sundararajan explains that many of the group’s 3.5 million live customers opened bank accounts after the group lent them money.

But none of the banks is lending to these people. “Our belief is that, based on their business track record and ability to service payments, at least 10-20% of them deserve all banking facilities.” Is Shriram’s application a conditional one? Sundararajan does not comment on the possibility, saying, “Suffice to say that our philosophy, thought process and strategy will not change with or without a bank for us.”

But these are the exceptions — as many as 26 aspirants filed applications with the Reserve Bank of India for banking licences, from large conglomerates and government bodies to microfinance lending institutions. This perhaps is proof enough that it may not be a great idea. Uday Kotak, principal founder and promoter of Kotak Mahindra, the most successful example of an NBFC transitioning to a bank, agrees. “The worst time to enter a business is when it is in high fashion. In 2001, when we got into banking, it was out of fashion and there were very few applicants. It has now become high fashion,” he says. 

It’s not an easy business, Kotak warns. “Banking is all about leverage. Equity is a very small portion of the total balance sheet of banks. We have ₹10 in capital and ₹100 in borrowings. If we lose ₹5 out of ₹110, we have lost 50% of our money. If we lose ₹10, we go home. Bankers find it difficult to keep this principle in mind. Most of the time, they believe they own ₹110.” It is this misperception — depositors think they are safe while banks are leveraged manifold — that many wannabes might want to cash in on. After all, banks usually have undeclared support and aren’t allowed to fail: either they get merged or bailed out. 

“For new applicants, the toss-up is between the freedom of an NBFC and the restriction of a banking entity with the incentive of safety and low-cost deposits,” says Amitabh Chaturvedi, executive vice-chairman, Purple India Holdings. Nevertheless, it is naïve to believe that just because you have a great brand and have put your board out, CASA (current account-saving account) deposits will pour in, warns Srinivasaraghavan. “That optimism is clearly misplaced. If you have five new players, all of them will be running after the same CASA and it is also not that the existing guys are going to sit still.” He’s right: even now, after decades of existence, only four banks — SBI, ICICI, HDFC and Axis — have CASA of over 40%.

Besides, well-run NBFCs have better return on assets (RoA) than major banks. That being a fact, the rush to become a bank is puzzling. If RoA is not the compelling reason, what is? Is valuation a possible vested driver? Says Sundararajan, “I am sure valuation will be at the back of the mind of whoever wants to become a bank, but that cannot be a driver. Short-term valuation may go up but, long-term, unless you have the business model and capability to run a bank, it doesn’t make sense.” Certainly, there are significant differences between how a bank and an NBFC operate. 

Advantage NBFC

R Balaji, vice-president (marketing & strategy), Mahindra Finance, states the difference. “Most of our customers are first-time borrowers; there is no income statement, bank documents etc. We take a call based on the person’s attitude and aspiration and when a customer repays his loan, his creditworthiness gets established. We are creating creditworthiness not evaluating it, which is what most banks and finance companies do.”

That said, so far, banks and NBFCs have co-existed cosily, with the former providing the latter all the credit they need: the top NBFCs get 80-90% funding from banks. “Banks’ ability to garner wholesale funding is unmatched. On the other hand, NBFCs have a role to play because banks find it difficult to go into unorganised markets,” says Srinivasaraghavan. Will things change as NBFCs turn into banks themselves? No, says Iyer.

“Our business model is positioned between a bank and a moneylender. The bank has low-cost deposits and is slow while the moneylender is fast but usurious. We are faster than the banks and slower than the moneylender and will continue to be relevant.” If new NBFCs-turned-banks continue to follow the NBFC model, the remaining NBFCs will evolve their business model accordingly, says Chaturvedi. He recalls, “From 1994 till 1998, NBFCs were into car loans, ICD and bill discounting and for Kotak, Lloyd and 20th Century, those were major products. In the current environment, NBFCs also provide loan against property, capital market financing, gold loans and SME lending.”

In many ways, it seems easier to manage an NBFC than a bank. Unlike banks, NBFCs do not have to set aside capital for mandatory reserves such as cash reserve ratio (CRR) and statutory liquidity ratio (SLR). They are under no compulsion to do priority sector lending either but they do it as they have perfected the process and find it profitable. It also does not hurt that there is a ready market — banks buy their priority sector exposure. NBFCs also have more flexibility when it comes to loan recovery. Chaturvedi says Section 138 of the Negotiable Instruments Act is one of the best examples. “In case of a bounced cheque, a bank has to deposit the cheque a second time. In case of an NBFC, if the cheque bounces, the NBFC will say, ‘I am going ahead with the next procedure if you don’t pay me my money’.”  

Bad old days

But it’s not as if NBFCs have had a free run all these years. In the not-too distant past, regulators have been openly sceptical of NBFCs, thanks to frauds and high failure rates. In the late 1980s and early 1990s, NBFCs mushroomed all over the country, and at the peak there were some 45,000 registered NBFCs — lax regulations and a booming economy meant even an individual could set himself up as an NBFC. 

All that changed in 1997. The carnage in domestic markets and a serious downturn in the auto sector (which had fuelled much of the boom) was followed by the CRB Capital Markets scam, where investors lost an estimated ₹1,200 crore. Shortly afterwards, the RBI introduced prudential norms for NBFCs. “CRB did not finance a single truck, but its ghost continues to haunt the sector even today,” laments Srinivasaraghavan. Perturbed by the unequal playing field that exists for NBFCs, he adds, “If the Usha Thorat committee wants us on par with banks with respect to provisioning, then it should be the case on the liability side also. Even within NBFCs, regulation has to be based on the kind of activity that they do.”

Regulations aside, the biggest cross NBFCs have to bear is their high cost of funding. For an NBFC, the liability side is determined by its rating and available liquidity. Hence, the only way to make up for the high cost is through higher yields. Mahindra Finance and Shriram Transport have a yield on advances of about 16-18% while banks make 12-13%. That also explains why their RoA of 2-4% is higher than most banks’ 1.5-2%. “Mahindra Finance has been able to maintain a RoA of 4% because it has controlled costs through large volume, has expertise to handle different scenarios and through technology intervention,” says V Ravi, CFO, Mahindra Finance.

High return ratios are also a function of the segment being lent to, according to Sundararajan. The banking system has a low-risk appetite, he says, so banks are happy servicing the same customers or the same kind of customers even if they get 4-4.5% net interest margins (NIMs). “Their appetite to write-off is only about 50 basis points (bps). If you are dealing with medium and small enterprises having irregular cash flows, you need 100 to 150 bps of loss appetite and that is possible only with a NIM of 7-8%.” 

Clearly, the profitability driver for an NBFC is its yield on advances and for a bank it is the low cost of funds. Srinivasaraghavan adds another factor, “Banks have a large fee income component. They are distributors of financial services, and for successful banks that is a huge piece.”

Also, while on paper, an NBFC can leverage its balance sheet 10 times, in reality, says Chaturvedi, it is never more than three to seven times. “Most NBFCs are non-deposit taking, growing on the basis of inter-corporate deposits, bank loans and financial paper placed with mutual funds and insurance companies. When an investor or lender looks at their balance sheet, he goes, ‘Your capital is ₹5,000 crore and you have already borrowed ₹20,000 crore. Let me not lend anymore to you.’ So, there is a possibility of a ₹5,000-crore NBFC not growing beyond ₹25,000 crore.” 

Despite these hurdles, NBFCs such as Sundaram, Shriram Transport and Mahindra Finance have registered stellar growth over the past several years. Among them, Mahindra Finance is the only one to have started as a captive and become a predominantly rural player. What, then, has been its modus operandi? 

Growth trajectory

Mahindra Finance was started in 1991 as a captive finance company for the group’s flagship utility vehicles business. The beginnings, in rural India, were basic, to say the least. Iyer, who has been with the company since 1995, recalls one of his earliest branch visits, where the office didn’t even have a toilet. “I realised how disconnected we were to a basic requirement and how, if provided, it could be a big motivator,” he says. As the business grew to include tractor financing, Mahindra Finance’s branch offices were also upgraded and the company took the crucial decision of relying on local talent.

This customer proximity and familiarity forms the backbone of the NBFC’s credit appraisal, disbursement and recovery process. Iyer says it is hard to overestimate the importance of getting this right. Not only is speaking the local language important, one also needs to know how the person is referred to locally. He cites an example, “If you go to Panvel [on the outskirts of Mumbai], almost everybody’s last name may be Patil, and if you ask where Patil stays, you will never find him. But if you say dadhiwala [bearded] Patil or cigarette dukaan [shop] Patil or doodhwala [milkman] Patil, even without the address you can find the man.” 

The increasing reach created its own momentum — the NBFC started selling products of other manufacturers as well, leading to a more diversified balance sheet. There’s also a visible change in the customer profile. Now, farmers aside, it also finances tractor-trolley people carriers, taxi operators, transporters, local contractors, traders, teachers, doctors and lawyers. This again has had its own benefits. Iyer explains, “When you work with farmers or farm-dependent customers, the cash flows are seasonal and unstructured but when you are servicing a multi-profile customer segment, the cash flow gets uniform and asset quality also improves.”

Not that it has been a smooth ride all this while. Field staff would have to go after the customer to get timely payment, which often meant travelling 80-100 km from the branch with no surety that the customer was available or had the money. Then, there’s the added challenge of handling large amounts of cash. Of the ₹1,800 crore Mahindra Finance collects monthly, 80% is in cash and coins. That means having to put in place appropriate risk management processes not only for collection but lending as well.

One option was to open multiple bank accounts, given that agents covered hundreds of kilometres. Consequently, Mahindra Finance has about 2,000 bank accounts across various clearing zones. Does that not create complexity in terms of monitoring? CFO Ravi agrees, but says the trade-off is between safety and cost control. “It is unsafe to mandate our 4,000 collection agents to collect cash and bring it back to the branch to deposit into a single account. Therefore, they deposit the cash at a mid-point.” Technology has also been brought into play. Often, customers would deposit money at the dealer point, since they had bought the vehicle there.

After the NBFC came across a few instances of dealer salesmen not depositing the money or its own employees taking the money and putting it in another defaulting account, it introduced a handheld device to give customers instant deposit receipts, account statements and also for keeping track of due dates. 

Similarly, clearly defined policies safeguard against lending malpractice. Lending decisions can be made at the branch level, where the branch accountant and manager are joint signatories on all approvals with the proviso that they can’t give more than 75% loan-to-asset value (LTV) at less than 15% for more than three to four years. As an additional backup, 12-15 chartered accountant firms audit branches across the country throughout the year.

The reports are presented to the audit committee board and Ravi says in a year there are two audit committee meetings just to review branch audit reports. While many of the NBFC’s insights relating to cash management and lending practices have been obtained through trial and error, those from the tractor lending business are perhaps the most interesting. 

Lending lessons

Mahindra Finance started financing tractors on the same lines as utility vehicles — 70-75% LTV and a three-year repayment, spread over monthly instalments. But loans started showing up as NPAs in three-four months and even as the NBFC considered repossessing the tractors, the borrowers themselves turned up and left the vehicles outside the branch. But disposing of the repossessed vehicle wasn’t as easy.

“We found there was no proper documentation such as the RC book because, being bought for farm use, the borrower never bothered registering the vehicle,” says Balaji. It didn’t take long for Mahindra to realise it had got the business model all wrong. The farmer’s cash flow was crop-dependent; his income came every six months or once a year and there was no way he could repay the loan on a monthly basis.

So, Mahindra Finance tweaked its offering, launching quarterly and half-yearly instalment schemes. “It is now clear to us that when we finance tractors, the customer’s ability to repay depends on the quality of harvest. Even in a good year, there are some parts in the country where the monsoon is not adequate. Repossession is not the answer to a drought,” says Ravi. Thankfully for the NBFC, since the past four to five years, tractors are increasingly being used for haulage as well, which has helped stabilise cash flows.

The insights obtained in the tractors lending business is now being extensively used in other parts of the business as well. Much thought now goes into plotting the cash flow of a potential borrower, says Balaji. For instance, the NBFC prefers financing three-wheeler cargo vehicles in Ahmedabad rather than Nagpur. “In Ahmedabad, you get ₹600-650 per trip compared with only ₹400-500 in Nagpur, which improves the economic viability of the asset.” The same varied repayment structure is also being used by the housing finance arm. With so much experience in lending, perhaps moving into banking would have seemed the next logical step for Mahindra Finance. So, why didn’t it take that step? 

On second thoughts

Originally, the thinking at Mahindra Finance was that since it was a large asset player on the rural side, banking would give it the opportunity to expand its balance sheet by adding low-cost deposits. It could also have cut down overheads by bringing the housing finance and insurance broking businesses under a common roof regulated by a central regulator. But when the NBFC sought clarity from the RBI on final guidelines, the clarifications played spoilsport. 

The central bank was firm that an NBFC and a bank cannot co-exist and the former would have to transition to a banking platform in 18 months. Iyer says, given the NBFC’s 675 branches and ₹30,000-crore loan book, it was impractical to believe the transition could be successfully made. Further, given the limited resources, how do you manage the incremental growth in customers and branch additions while effecting the changeover? If slack would have built into the system in terms of recovery, then rising non-performing assets would create a whole new problem. 

Also, given that not all branches would have met certain minimum standards, including a strong room or being in an unbanked area, would have meant closing them down. And when you close a branch, not only is new business lost, but word could also spread that the NBFC has closed, thereby increasing voluntary defaults.

Maintaining CRR and SLR would have taken its own toll. In FY13, Mahindra Finance had an RoA of 4% and RoE of 24%, which would have been drastically hit if it had turned into a bank. “Our loans have an average tenure of two to three years and they will be paid off over a period of time. We would have ended up keeping CRR and SLR on an asset that is running off, and we felt it was not commercially viable,” says Iyer.

Pankaj Agarwal, banking analyst, Ambit Capital, says that it makes sense to run an NBFC separately is evident as, “Even nine years after receiving a banking licence, Kotak Mahindra is still running its car financing business as an NBFC subsidiary. This subsidiary contributes 21% of consolidated profits and has delivered better profitability growth (46%) over FY07-12 versus consolidated earnings growth (28%) for Kotak Mahindra Bank over the same period.” 

So, why did Kotak Mahindra become a bank? “We took the call then because we felt we needed to make our model appropriate to serve customers better. For the first five-six years of our life as a bank, particularly between 2003 and 2008, not many wanted to keep money in bank deposits, people wanted the excitement of equities and that’s the time we grew in banking,” says Kotak.

Given that the RBI won’t be keen to open another debate in the future, it seems likely that it will ask Kotak and the other banks to run their NBFC activity under a single entity. Iyer will be keeping an eye out for that development but until then, it is business as usual. 

Going deeper 

Currently, Mahindra Finance’s customers come from 170,000 villages all over India. That’s barely scratching the surface, believes the NBFC. “If we look at India as a country with 600,000 villages, we can still cover a lot of ground by doubling our presence over the next five years,” says Iyer. The potential for the rural housing finance arm, in particular, excites him. The division took shape as a customised offering for a segment that has no credit availability — it offers creditworthy customers home completion loans of ₹1-1.5 lakh with a repayment period of three to five years.  

Having ventured in three years ago, Mahindra Rural Housing Finance today has a ₹1,000-crore book, which Iyer sees growing to ₹5,000 crore by FY16. Managing director Anuj Mehra says much of this growth could come from a southern market such as Tamil Nadu where aspiration to do up the house is high and there is familiarity with small credits. Madhya Pradesh is also a market that excites Mehra given its clear land titles.

Home completion loans are the only financing avenue where the NBFC does not lend for asset creation and here it protects itself by funding 75% of the cost of construction. So when a farmer wants to put up a roof, it will finance 75% of the roof’s cost but the entire house and the land is taken as collateral. To secure itself from a default or surreptitious sale, the lien is marked in the NBFC’s favour, after which it depends on the grapevine to keep it posted of any change. “As Indians, we love to poke our nose into other people’s business. If somebody pledges his house, you can rest assured that the whole village knows about it,” laughs Mehra. 

That witticism aside, before extending any credit, his agents thoroughly field investigate a potential borrower’s creditworthiness. They visit his house, see his land, what he is growing etc. “We have gathered information from each area about approximate income levels for various occupations particular to that area. So, we know whether someone makes ₹250 or ₹750 a day.

Using that, we are able to estimate what the monthly income is likely to be, once we have investigated what he actually does,” says Mehra. Some of the findings are surprising, such as that incomes for the same occupation can differ across state borders. A mason in Tamil Nadu on the Kerala border, for instance, earns much more than one in north Tamil Nadu. Think about it and it makes sense: Kerala is highly unionised, so income levels there are bloated. 

This understanding of local nuance has also helped in the creation of custom-built insurance products, a segment where the NBFC sees big opportunity. The insurance broking arm was launched in 2004 with an initial capital of ₹50 lakh and has since underwritten policies worth ₹620 crore. Jaideep Devare, managing director, Mahindra Insurance Brokers, says that here, too, the company has brought in its “tested approach of customisation”. Given the lack of adequate documentation in rural India, it convinced insurance companies to accept proxy documents. “A panchayat is now able to give a certificate that is accepted by the insurance companies to process a claim,” he says. 

The other challenge was convincing insurance companies about the inability to conduct a rigorous medical test for a life protection or health insurance product. “For an insurance company, the complexity can be simplified if you can give them an all-India distributed risk. That is how we convinced them,” adds Devare. Soon after, with OM Kotak, it launched Loan Suraksha, a policy that insures the borrower against fatality.

The policy insures the life of the borrower and is equal to the outstanding loan amount. If there is a claim, the insurance company pays Mahindra Finance and the family is offered either the vehicle or the residual claim money. Since in most cases, the owner and the borrower happen to be the same, the family also gets protection against default. Similarly, to offer health protection it has rolled out Arogya Suraksha in collaboration with Royal Sundaram.  

Ground zero

Amid all this excitement, does Iyer worry about competition getting intense in the rural markets where his NBFC reigns? Not really, it seems. He says competing in rural markets is not a cakewalk as there is a fixed level of costs in terms of borrowing, asset quality and overheads. “How many of them can come to market and say they have 675 branches or 2.5 million customers? These differentiators have been built over the past 12 to 15 years. Even if somebody does all this, it will take them five to seven years, if not more. By that time we would have doubled ourselves,” he points out.

Clearly, those coming in now cannot price themselves lower unless they are willing to compromise on returns. If not, in their hurry to expand they might end up compromising on asset quality. 

It’s not just a legacy advantage. Mahindra Finance also has an edge in the referral volume its existing customers generate. About 15-20% of its monthly business is self-generated and, ironically, Balaji is enthused that several competitors are trying to become banks.

The larger the balance sheet, the larger will be the negative impact of CRR/SLR, which is why those rivals will want to curtail the balance sheet to some extent. “Over the next two years, they will be preoccupied in converting their existing branches into bank branches and their focus will be more on transition than enhancing growth. That creates opportunity for us,” he remarks.

Mahindra Finance plans to add 40 to 50 branches every year and Agarwal thinks the NBFC can continue to grow at the current pace without a banking licence for another five to six years. The big hope, thereafter, is that the RBI will keep issuing banking licences on an on-going basis and more feasible guidelines will enable more hopefuls to enter.

Meanwhile, Federer’s poor form continued at the US Open in September, where he crashed out in the fourth round. But only someone completely ignorant would write-off the 17 Grand Slam titles winner. It would be equally foolish for competition to ignore Mahindra Finance just because it decided not to become a bank…for now.