Finance Companies Past, Present and Future

Globalisation of the banking sector presents a unique set of challenges. Nepal ’s tryst with the financial sector development has been around for a little over twenty years.
The development in this sector actually started in the mid-1980s with the entry of foreign banks in joint venture with Nepali promoters breaking the monopoly of the state-owned banks. Non Banking Financial Institutions (NBFIs) started being licensed in 1984 with lower capital requirements for such institutions than for the banks and it marked the need for more players in the market to expand the access of services to the general public. However, the actual proliferation of finance companies did not commence until the mid 90s. This article attempts to track the growth in this sector, the regulatory constraints and whether such players were really needed in the financial market.
According to the findings of the Access to Financial Services Survey by the World Bank et al. (2006), only 26 percent of Nepali households have deposit accounts and 15 percent have loan accounts with banks and formal financial institutions. There has been an exponential increase in the number of finance companies: in 1984 there was only one, in 2007 there are 79. However, despite the high number of finance companies, they manage to serve only 2 per cent of the population. Therefore, the expectation of mid-90s that the hordes of licenses issued for setting up finance companies would expand the financial services and make it accessible to the masses has not been fulfilled. It has only increased the number of players who are competing with each other for a share from the same segment of the market.
Historical Background:
The Finance Companies Act-2042 introduced in 1984 was the first law that governed the operation and limitations of finance companies. It allowed finance companies to take deposits from the people and make investment on hire purchase, housing industry, commerce etc. In effect they were allowed to operate as mini banks. Some eight years later, the Merchant Banking Act 2050 allowed certain finance companies that met the regulatory requirements to acquire Merchant Banking license as well. As of 2007 data there are 8 Non-Banking Financial Institutions (NBFIs) with Merchant Banking license. This has been, from the beginning till date, the only major difference between a commercial bank and a finance company in terms of the activities allowed to them. The only areas reserved for the commercial banks are : over drafts, personal loans, foreign exchange transaction and opening letters of credit. Recently, the finance companies are allowed to transact also in Indian currencies though they are still restricted from transacting in other foreign currencies. In order to govern this sector more prudently, the Banks and Financial Institutions Act 2061 (also known as the Umbrella Act) was introduced by replacing all the other earlier Acts thus making this the single Act that governs all financial sector players from commercial banks to finance companies. The banks and financial institutions are divided into various categories fixing the extent of permitted services based on the capital. The players with the highest capital base are the commercial banks and they are given class “A” category; development banks class “B” category, Finance Companies class “C” category and Micro-Financing Institutions and Cooperatives are given class “D” category. Products and services are allowed according to the category an institution belonged to. Although this has been in line with the principle of prudential regulation and it has enabled the Nepal Rastra Bank to incorporate all the formal players in the financial sector under its regulatory jurisdiction, the purpose of making financial services endemic has not materialised. All it has done is dividing the number of players into capital structured groups. However, the Umbrella Act along with the prudential regulations of the Nepal Rastra Bank has made this sector the most transparent and highly regulated industrial group, which is positive development despite the frequent changes in directives.
Efficiency Parameters:
Growth in numbers, across the financial sector, has failed to address the main issue of accessibility. Ironically, the reach to the masses is in decline.
Between 1992 and 1995, Nepal Rastra Bank licensed almost three dozen finance companies. The need at that time was to make financial services more accessible to the general public. The handful of joint-venture commercial banks in operation during that period were more inclined to serve institutions and high net-worth customers. The newly licensed finance companies filled this void initially by catering to the general urban populace.
But the premise that wholesale banking would continue in the commercial banking sector and finance companies would enter consumer and retail financing and be a replacement for the informal sector was short-lived. In the beginning, the simple process and quick sanctioning of loans by the finance companies as opposed to the long and cumbersome process of the commercial banks appealed to the average urban population. Therefore, the finance companies can be given credit for initiating the practice of providing higher yielding depository products and expanding access to formal loans in a market where people were subject to stringent loan procedures of the government-owned and joint-venture commercial banks. As competition in the entire banking and finance sector grew, the demarcation began to be vague. Furthermore, all the players, whether a bank, development bank or a finance company was vying for a share out of the same market pie.
Time series data of finance companies (aggregate) from 1994 to 2006 show that there has been an 1156 percent average annual growth in deposits, but corporate deposits are increasing and slowly displacing individual deposits and finance companies are heavily dependent on commercial banks for borrowing. What has transpired is that finance companies have serviced an area which used to be exploited by the informal sector, but due to increasing competition and proliferation of commercial banks they are losing market share to the commercial banks.
On the loan side, there has not been significant difference in the percentage of outstanding loans between 1998 and 2004. Term loans increased by 5 percent in 2004 as compared to 1998, the year when this type of loan commanded the highest weighted exposure (i.e. 40 percent). Housing sector took second place at 30 percent in 2004 (29 percent in 1998), which was a negligible increment. The loan exposure was strictly limited to the urban areas. Data to support the increasing trend of loans for purchase of stocks listed in the stock exchange and for financing the purchase of shares in the IPO (Initial Public Offering) of the companies was not available at the time of writing this article, but finance companies have been heavily exposed recently in advancing funds for such margin trading and IPO investment. To stop this trend, Nepal Rastra Bank directed in March 2007 (NRB 2063/12/8) all finance companies and banks not to advance loans for IPO investment in the first week of the scrip’s floatation and allowed such loans only if the scrip was under-subscribed after the first week of floatation. Subsequently, more stringent regulations were directed towards equity financing which is misconstrued and popularly known in Nepal as ‘margin trading’. However, this has not forced many of the finance companies from withdrawing from this area of investment as it has been extremely profitable. The present trend, as it is heading, continues to show a ‘drifting away’ of investment from the real sector towards more lucrative and highly profitable yet extremely risky and volatile stock market.
Regulatory Development:
Finance Companies Act of 1984 allowed the inception of finance companies. After allowing Merchant Banking activities in 1992, the only significant change in operations commenced in 2004 with the Banks And Finance Companies Act (BAFCA). Finally, finance companies, in addition to their limited activities, were allowed to be members of the check clearing house, transact in Indian Currency and were authorized to do that in real estate business.
Subsequent directive in 2005 allowed finance companies to be able to provide debit and credit cards by being subsidiary members of banks. Finance Companies henceforth were expected to follow all prudential regulations that commercial banks were following. One of the biggest changes, after the Umbrella Act came into operation, was on the balance sheet of finance companies as they were now to follow cash-based accounting system as opposed to accrual-based in the past along with strict provisioning and interest suspense allocations. The stringent reporting requirements also compelled them to upgrade their technology to be in compliance with NRB reporting standards.
This was a wake up call to many of the finance companies which operated as a family-run business. Overnight, prudential regulations were in effect compelling them to transform and be transparent. The Umbrella Act was a beginning towards harnessing all the various players towards operating in a transparent and highly regulated system. The Umbrella Act of 2004 narrowed the gap between a commercial bank, a development bank and a finance company. However, none of the new directives were enablers to make the financial sector more endemic or far reaching. The new directives only increased the competition in an already over-crowded market and attempted to enforce prudential regulations on all players. Out of the three categories, it is only the finance companies group that belong to category "C", that may boast that not a single member of that group has been penalised for misconduct of operations or on any other issue by NRB. A few banks in category "A" and "B" have been taken under NRB management due to misappropriation and non-compliance to directives.
Constraints:
If the mandate of the finance companies was to be an arbiter between borrowers and lenders for the masses then the whole exercise has not quite been successful. But if the intention was to create a parallel institution with lesser capital to cater to a segment that commercial banks avoided, then the finance companies have served that purpose.
The constraints to reaching out to rural areas have been many:
1. Loans are dependent on collateral of immovable assets and there are strict provisioning requirements.
2. Project loans based on security of equipment is risky due to lack of secured transaction register
3. Lack of monitoring capability and dearth of skilled manpower who are willing to re-locate
4. Security and slow legal framework
5. Inconsistent directives from the regulator
Now let’s analyse these points in further depth. The trend of loans and advances based on collateral of immovable assets as a primary source of recourse to possible default has been the biggest impediment in reaching out to the rural poor or to an entrepreneurial group that can produce no immovable asset as security. The other reason behind this is the NRB guidelines that require heavy provisioning for loans secured by any means other than collateral of immovable assets and equipment. This has been a deterrent to the lending institutions who do not wish to take overt risks.
Sources and Uses of Fund of Finance Companies (Aggregate)
Although the Secured Transaction Act was passed in 2006, safety of collateralised equipment is still not there due to the lack of the secured transaction registry. The risk is that it is very difficult to track the equipment collaterised and the same equipment can be used as collateral in a number of lending agencies. Once the registry comes into operation, the problem is expected to be solved.
There has been a dearth of skilled manpower in this sector willing to go to remote areas to work. The cost of monitoring projects outside the urban areas is high. This, coupled with the security risks, has acted as major deterrent in recent times.
The financial sector has been the fastest growing industry quantitatively and, as a result of new innovations and technology, is the most progressive. Unfortunately, the legal system has not been able to keep pace with this development. Reform in the legal apparatus is urgently needed to facilitate quick decisions in this sector. The Debt Recovery Tribunal set up in 2001 has tried to address the legal problems on behalf of the financial sector, but the process is usually slow. Constant stay orders from the courts have been major impediments to the due process.
Regulatory directives are not consistent and can change at any pressure from parties with vested interests. Directives have been known not to be applicable to a few players and have been changed to facilitate them. This will undermine the regulator's capacity and cast doubt on the slogan of good governance being propagated.
The future:
As competition grows fierce with new players setting up business with larger capital, the existing finance companies need to strategically think ahead by increasing capital, setting up systems to cope with rising competition and explore new markets. The future for this category of financial institutions lies in the success to determine the appropriate customer mix and business mix to grow profits at high rates, with a strong focus on fee-based revenues.
Banking in terms of conventional methods needs to be revamped and the regulatory authority should allow investment banking products to be introduced into the market. In order to facilitate this, the government has to allow an independent rating agency to be set up.
The classification of the financial institutions in A, B, C, and D categories is meaningless in this market as some C category companies have a stronger balance sheet as well as compliance record and management than some "A" and many "B" category institutions. An independent credit rating agency will enable a balanced rating based on the financial strength of an institution and not on the capital base alone. In turn, this will be a stronger encouragement for the public to deal with the institutions that have higher ratings, thus compelling the weaker players to improve their operations. The market will force them to correct themselves.
The recent retail-led boom has helped the banking and financial sectors overcome the stalemate in corporate lending and has been the fuel for growth in this sector. However, this trend involves massive competition. Therefore, sustainability for the players is getting exceedingly difficult. The future will also depend on the collaboration between the financial institutions, which should inevitably lead to mergers.
Non-banking financial institutions (NBFI) should be allowed to expand their product base so that their fee based income will increase to occupy larger share in the total income. New instruments along the lines of investment banking products, should be encouraged. Mutual funds management should be allowed to NBFIs. A clear demarcation of activities should be adhered to as per the directives and the regulator should have strict guidelines enforcing these rules.
Conclusion:
The finance sector has shown maturity in recent years. The positive trend is also due to the strict regulatory guidelines for those who follow them. However, innovation in this sector is lacking. In order to be competitive in this market, finance companies need to collaborate and start thinking and planning mergers to create a larger capital base. The future for small capital base companies is limited. There has to be a paradigm shift in the regulations to facilitate development in the financial sector. Financial innovation can only take place if it is allowed from the regulatory angle; otherwise, redefining the wheel and calling it an innovative product will continue to be the trend in the banking and financial sector.