Even as funding costs for NBFCs are rising, strong credit demand fuelled by robust economic growth will support the sector’s profitability. Further, robust economic conditions will help NBFCs preserve asset quality despite elevated interest rates increasing the debt burdens of borrowers, according to Moody’s Ratings.

“NBFCs’ profitability will moderate somewhat in the next 12-18 months as funding costs for them will increase. We also expect the sector’s credit costs to increase from cyclically low levels, especially as unsecured loans mature,” the note said, adding that strong capitalisation will enable NBFCs to expand their balance sheets.

The ratio of capital to risk-weighted assets for the sector rose to 27.6 per cent as of September 2023 from 23.1 per cent in March 2020, driven by growth in internally generated capital and improved profitability. Aggregate return on assets (ROA) increased to 2.9 per cent from 1.3 per cent during the period as net interest margins (NIMs) widened and credit costs decreased.

Loan growth for NBFCs accelerated to 20.8 per cent as of September 2023 from 10.8 per cent a year earlier, driven by demand for retail loans, including housing and automobile financing.

The global agency expects NBFCs to grow by about 15 per cent over 12-18 months, driven by various types of lending, including infrastructure financing by large government-owned NBFCs and SME loans. However, growth in unsecured retail loans will slow after the increase in risk weights by the RBI.

Funding costs for large NBFCs rose about 50 bps in FY24 due to bank borrowings becoming more costly, which are expected to become more costly in the next 12-18 months as banks are also still repricing their NBFC loans to reflect the rate hikes by the RBI in 2022-23.

“Banks will pass higher deposit costs onto borrowers, including NBFCs, after raising deposit rates to attract more deposits as credit demand outstrips deposit growth,” Moody’s said, adding that it expects some NBFCs to reduce unsecured lending and increase secured lending following the increase in risk weights.

While this shift is positive for NBFCs’ asset quality, it will weigh on their margins as yields on secured loans tend to be lower. Yet, many NBFCs have passed increases in funding costs onto customers, which will help mitigate pressure on margins.

The larger NBFCs, which have access to diverse funding sources, including retail deposits and external commercial borrowing, will see margins hold up better given their greater funding flexibility. Further, NBFCs with strong asset quality, or those lending to priority sectors, will have the option of securitising assets for funding.

“Liquidity conditions for NBFCs will be stable, supported by access to undrawn bank lines and their well-tested ability to sell down or assign loans to banks under tight funding conditions. Large NBFCs mostly comply with the RBI’s liquidity coverage ratio requirements, which will take full effect in December 2024. They have also reduced their dependence on short-term funds for lending purposes, lowering roll-over risks under stressed market conditions,” Moody’s said.

The share of short-term borrowing in the total borrowing of the top 50 NBFCs decreased to 37.3 per cent in September 2023 from 47.7 per cent in September 2018.

As a result, NBFCs’ NPA ratios are expected to remain below pre-pandemic levels, but the recent rapid growth in unsecured loans poses asset risks for NBFCs as sizable proportions of their loans are new and are untested through economic cycles, it said.

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