ICRA Rating Feature

ICRAs Credit Rating Methodology for Non-Banking

Finance Companies
Non-Banking Finance Companies (NBFCs) play an important role in the Indian financial market. While the
Reserve Bank of India (RBI) reglates !oth NBFCs and !anks" there are some significant differences in the
reglatory treatment" #ith NBFCs !eing given greater fle$i!ility in governance strctre and operational
matters" and !eing allo#ed to lend independent of priority-sector targets and of stattory reserve
re%irements. &o#ever" at the same time" there are reglatory restrictions on the !o%et of services that
NBFCs can offer and on their fnding options. 'ypically" NBFCs e$tend the follo#ing types of loans(
)ehicle loans (for prchase of commercial vehicles" cars" t#o-#heelers" etc.)
Constrction e%ipment loans
*ersonal loans
+icro credit
,oans against property
,oans against shares
Corporate loans
Infrastrctre loans
*ro-ect finance loans
In rating an NBFC" ICR. evalates the company/s !siness and financial risks" and ses this evalation to
pro-ect the level and sta!ility of its ftre financial performance in varios likely scenarios. 'he ratings are
determined on a 0going concern1 !asis rather than !eing !ased on a mere assessment of the company/s
assets and de!t levels as on a particlar date. 'he !road parameters for assessing the !siness and
financial risks of an NBFC (as in the !llet list !elo#) are discssed at length in the ne$t t#o sections. 'his
methodology note does not prport to !e an e$hastive discssion on all the rating parameters involved in
the credit rating of NBFCs" !t presents a !road frame#ork for the e$ercise.
Business Risk
o 2perating 3nvironment
o 2#nership 4trctre
o Franchise and 4i5e" competitive position
o +anagement" 4ystems and 4trategy" governance strctre
Financial Risk
o .sset 6ality
o ,i%idity
o *rofita!ility
o Capital .de%acy
While several parameters are sed to assess an NBFC/s !siness and financial risks" the relative
importance of each of these parameters can vary across companies" depending on its potential to change
the overall risk profile of the company concerned. For instance" in a !enign operating environment" a
relatively ne# 0personal loan finance company1 may sho# very good profita!ility" !t may !e na!le to
sstain the same throgh several life cycles. 'herefore" in this case" higher #eight #old !e attached to the
company/s !siness risk profile than to its financial performance. Frther" an NBFC #ith a strong !siness
profile and sta!le financial performance #old !e vie#ed more favora!ly than another #ith compara!le or
!etter financial nm!ers" !t #ith a #eaker !siness risk profile.
ICRA Rating
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ICRAs Credit Rating Methodology for Non-Banking
Finance Companies
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BUIN! RI"
ICR. makes an assessment of an NBFC/s !siness risk !y analysing" among other factors" the company/s
operating environment" franchise" asset %ality" and management and systems. .s many of these
parameters are %alitative" ICR. tries to remove the s!-ectivity in its analysis !y captring and assessing
information on defined s!-parameters" and sing these to make a comparison across varios companies.
'his analysis also incorporates ICR./s assessment of the performance of varios sectors" its otlook on
the economy" and its vie#s on isses related to the operating environment.
#perating !n$ironment
'he operating environment has a significant !earing on an NBFC/s credit rating as it can impact its
gro#th prospects and asset %ality %ite considera!ly. In assessing the operating environment" ICR.
looks at the overall economic conditions" prospects of the indstry related to the asset class !eing
financed" and the reglatory environment. For instance" in the case of a commercial vehicle (C))
financing NBFC" the level of economic activity and freight rates are very important" -st as the otlook
on real estate is important for a home finance company" from the perspective of !oth asset creation
and asset %ality.
For an NBFC" reglatory changes can significantly impact (either positively or negatively) credit
losses. For instance" the esta!lishment of the credit information !rea has helped lenders take
informed credit decisions" #hile 'he 4ecritisation and Reconstrction of Financial .ssets and
3nforcement of 4ecrity Interest .ct" 7887 (4.RF.34I) has helped them recover real estate !acked
loans more efficiently9 at the same time" recoveries from nsecred asset classes and vehicle loans
have !een hit #ith the reglator taking a strict vie# of the recovery procedre follo#ed !y some
financiers.
Intensity of competition has a significant !earing on the credit profile of an NBFC" given that the
prevailing or anticipated competitive intensity #old inflence the company/s gro#th prospects"
earnings and management strategy. ICR./s evalation focses on the crrent level of competition as
#ell as the attractiveness of the segment for potential competition !y assessing several factors
inclding gro#th potential" entry !arriers and risk-ad-sted retrns.
#%nership tructure
2#nership strctre cold have a key inflence on an NBFC/s credit profile in that a strong promoter
and strategic fit #ith the parent can !enefit an NBFC/s earning" li%idity and capitalisation" and hence
its credit profile. In assessing an NBFC/s o#nership strctre" the parameters e$amined inclde"
among others( the credit profile of the promoter" shareholding pattern of the NBFC" operational
synergies of the NBFC #ith its promoter" level of involvement of promoter in the NBFC and level of
commitment" and track record of the promoter in providing fnd spport.
&o$ernance tructure
ICR. !elieves that an appropriate :overnance strctre is important to ensre that the po#ers given
to line managers at an NBFC are e$ercised in accordance #ith the esta!lished procedres and that
these procedres are in harmony #ith the !road policy gidelines and strategic o!-ectives of the
NBFC. ICR./s evalation of an NBFC/s :overnance strctre involves an assessment of the
strctral aspects of the Board and Board level committees and of the fnctioning of the varios Board
committees.
Franchise and i'e
For an NBFC" its franchise strength determines its capacity to gro# #hile maintaining reasona!le risk-
ad-sted retrns" and to maintain resilience of earnings" there!y facilitating predicta!ility of its ftre
financial performance. It may !e noted that an NBFC #ith a significant market share and a niche
player can !oth have a defensi!le franchise
;
" #hich cold in trn !enefit their credit profile.
.s for si5e" typically it is seen in relation to an NBFC/s loan mi$ and has a !earing on the company/s
competitive position" diversity" credit risk concentration" sta!ility of earnings" and financial fle$i!ility.
$
%he &igger company on the strength of its standing in the oerall market and the smaller one
on account of its uni'ue o(ering or its strong relationship )ith the key participants in the credit
chain of the target segment*
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ICRAs Credit Rating Methodology for Non-Banking
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Management( ystems and trategy
6ality of management" systems and policies" shareholder e$pectations and the strategy follo#ed to
manage these e$pectations" and acconting %ality are the fondation stones on #hich an NBFC/s
credit risk profile is !ilt. 'he importance of these factors is even higher for a ne# NBFC" one #ith a
shorter track record" or one #ith a changing !siness profile.
In evalating an NBFC/s management" systems and strategy" ICR. assesses the company/s
competitive position (a!ility to change lending norms and<or yields)" reliance on otsorcing" pace of
gro#th and responsiveness to market changes" track record" and management e$perience (in relation
to gro#th plans and the lifecycle of the loans e$tended)" !esides the e$tent of diversification in its loan
!ook.
.s for track record" this is evalated in relation to completed !siness cycles. 'hs" #hile a five- to si$-
year-old car finance company is considered to have a reasona!le track record (the typical loan tenre
!eing three to for years)" a home finance company of the same vintage #old !e said to have an
average track record (the typical loan tenre !eing ;= to 78 years). Frther" if an NBFC is e$panding
into ne# prodcts and geographies" its track record and management e$perience may not provide the
same level of comfort as those of another NBFC #ith a sta!le gro#th rate and gro#ing #ithin e$isting
geographies #ith the same loan mi$.
.ll credit ratings" inclding those in the NBFC sector" necessarily incorporate an assessment of the
%ality of the isser/s management" as #ell as the strengths<#eaknesses arising from the isser/s
!eing a part of a 0grop1. 'his part of the e$ercise is mostly s!-ective" althogh the actal track
record of the management is a spporting factor. >sally" a detailed discssion is held #ith the
management of the isser NBFC to nderstand its !siness o!-ectives" plans and strategies" and
vie#s on past performance" !esides the otlook on the indstry. 4ome of the other factors assessed
are(
o 3$perience of the promoter<management in the NBFC/s line of !siness.
o Commitment of the promoter<management to the NBFC/s line of !siness.
o .ttitde of the promoter<management to risk taking and containment.
o 'he NBFC/s risk management policies (credit risk and market risk).
o 4trength of the other companies !elonging to the same grop as the NBFC.
o 'he a!ility and #illingness of the grop to spport the NBFC concerned throgh
measres sch as capital infsion" if re%ired.
. carefl evalation of the risk management policies of the NBFC is done as that provides
important gidance for assessing the impact of stress events on the li%idity" profita!ility" and
capitalisation of the company concerned. ICR. compares the nder#riting policies of the NBFC
concerned #ith the !est practices in the indstry to make an assessment of the company/s risk
profile. 'he process of risk profiling also involves evalating the NBFC/s !siness sorcing
practices (in-hose vs. otsorced)" !esides its recovery and monitoring systems.
ICR. also evalates the strategy and !siness plans of the NBFC" along #ith the shareholders/
e$pectations from the company. .lthogh ICR.-assigned ratings are for de!t holders" meeting
shareholders/ e$pectations is imperative as other#ise the company/s strategy itself cold ndergo
a change (to meet shareholders/ e$pectations)" #hich in trn cold alter its credit profile.
FINANCIA) RI"
Asset *uality
.sset %ality plays an important role in indicating the ftre financial performance of an NBFC. 'he
focs of asset %ality evalation is on lifetime losses" varia!ility in losses nder varios scenarios" the
impact of likely credit costs on profita!ility" and the cshions availa!le (in the form capital or
provisions) to protect the de!t holders from ne$pected deterioration in asset %ality.
In evalating an NBFC/s asset %ality" ICR. assesses the %ality of the company/s credit appraisal
process and lending norms" the riskiness of its loan mi$" its risk appetite" the availa!ility of data to
facilitate credit decision making" and its track record in managing its loan !ook throgh lifecycles.
.ssessment is also made of credit risk concentration" trend in via!ility of cstomers" trend in
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ICRAs Credit Rating Methodology for Non-Banking
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delin%encies (ad-sted for vintage of the !ook)" :ross N*.? percentage" Net N*. percentage" and
Net N*.s in relation to Net Worth.
Frther" the e$tent of diversification is also an important indicator of an NBFC/s asset %ality. In
assessing diversification" the factors generally looked at inclde loan mi$" credit risk" portfolio
granlarity" geographical diversification" and !orro#er profile. &igh levels of diversification can shield
an NBFC from the impact of do#ntrn in any one segment. .t the same time" diversification into riskier
segments may not improve resilience and therefore may not translate into sperior ratings. &o#ever"
an NBFC/s a!ility to manage diversification" especially in mltiple !sinesses and<or ne# geographies
is a very important isse" -st as management depth and the a!ility to adopt the skills and techni%es
needed to rn different !sinesses are.
.s asset %ality indicators can vary" depending on the asset class" !orro#er profile" N*. recognition
norms" and the acconting policy on #rite-offs" comparing these indicators across NBFCs operating in
different asset classes may not yield meaningfl reslts. ICR. therefore makes a comparison of the
delin%ency levels (at @8daysA" B8daysA" C8 daysA) for the same asset class and !orro#er profile
across players" ad-sted for #rite-offs. When availa!le" static pool analysis is done as this gives a
meaningfl estimate of the losses at varios stages in the loan cycle as #ell as of the overall lifetime
losses" and is free from the distortions cased !y a high gro#th rate.
)i+uidity
It is important for an NBFC to maintain a favora!le li%idity profile for the smooth fnctioning of its
fnding activity (fresh asset creation) and to honor its de!t commitments in a timely manner. It is also
important that an NBFC manage its interest rate risk" as the same cold impact its ftre profita!ility.
In assessing an NBFC/s li%idity profile" ICR. evalates the company/s policy on li%idity" the matrity
profiles of its assets and lia!ilities" the asset-lia!ility matrity gaps" and the !ackps availa!le to plg
sch gaps. 'he evalation also focses on the diversity of the NBFC/s fnding sorces and their
%ality (i.e. availa!ility of these sorces in a stress sitation).
,rofita-ility
.n NBFC/s a!ility to generate ade%ate retrns is important from the perspective of !oth its
shareholders and de!t holders. 'he prpose of ICR./s evalation here is to assess the level of ftre
earnings and the %ality of earnings of the NBFC concerned" #hich is done !y looking closely at the
!ilding !locks( interest spreads" fee income" operating e$penses" and credit costs.
'he evalation of an NBFC/s profita!ility starts #ith the interest spreads (yields mins cost of fnds)
and the likely tra-ectory of the same in the light of the changes in the operating environment" the
company/s li%idity position" and its strategy. 'he a!ility of the NBFC to complement its interest
income #ith fee income is also assessed. . large fee income allo#s greater diversification" #hich in
trn can improve the resilience of earnings" there!y improving an NBFC/s risk profile. .fter assessing
the income stream" ICR. evalates the NBFC/s operating efficiency (operating e$penses in relation to
total assets" and cost to income ratio) and compares the same #ith that of its peers. Finally" the credit
costs are estimated on the !asis of the company/s asset %ality profile" and the profita!ility indicators
7
compared across peers. Importantly" a very high retrn on e%ity may not necessarily translate into a
high credit rating" given that the nderlying risk cold !e very high as #ell" and !eing so it cold !e
more volatile or difficlt to predict.
Accounting *uality
Consistent and fair acconting policies are a prere%isite for financial evalation and peer grop
comparisons. By virte of !eing incorporated nder the Companies .ct" ;C=B" NBFCs are re%ired to
follo# the .cconting 4tandards prescri!ed !y the Institte of Chartered .ccontants of India. Frther"
the RBI has also issed prdential norms for NBFCs specifying the acconting methods to !e sed for
income recognition" provisioning for !ad and do!tfl advances" and valation of investments. In
evalating an NBFC/s acconting %ality" ICR. revie#s the company/s acconting policies" notes to
the acconts" and aditors/ comments in detail. Deviations from the :enerally .ccepted .cconting
*ractices are noted and the financial statements of the NBFC ad-sted to reflect the impact of sch
deviations.
-
Non-!erforming Assets
7
!ro.t after %a/ as a percentage of Aerage %otal Assets0 and !rofit after %a/ as a percentage of
Aerage Net 1orth
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ICRAs Credit Rating Methodology for Non-Banking
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Capital Ade+uacy
.n NBFC/s capital provides the second level of protection to de!t holders (earnings !eing the first) and
therefore its ade%acy (in relation to the em!edded credit" market" and operational risk) is an
important consideration for ratings. Riskiness of the prodct and granlarly of the portfolio are factors
that have a significant !earing on the amont of capital re%ired to provide the desired degree of
protection to an NBFC/s de!t holders. 'he re%irement of risk capital varies #ith the concentration and
the riskiness of the prodct mi$" as the follo#ing chart sho#s.
Chart ./ Risk Capital Re+uirement Matri0
3$pected credit losses and varia!ility
,o# &igh
*
o
r
t
f
o
l
i
o

C
o
n
c
e
n
t
r
a
t
i
o
n&igh +oderate &igh
,o# ,o# +oderately high
ICR. starts #ith the ad-sted capital (as discssed in the section on .cconting 6ality) and
considers the internal capital generation and possi!le spport from a strong parent<grop company
#hile evalating the ade%acy of an NBFC/s risk capital for a particlar rating category. 'ypically"
capital ade%acy analysis is done for the individal !siness lines (inclding off-!alance sheet
portfolio/s) of the NBFC and the 0aggregated capital re%ired1 compared #ith the actal capital
availa!le as #ell as #ith the minimm capital that the company is e$pected to maintain.
ICR. also evalates the %ality of an NBFC/s capital" apart from the level of capital. . higher
percentage of 'ier I capital is vie#ed more favora!ly" given its greater permanence. Besides" an
NBFC/s a!ility to meet reglatory capital ade%acy re%irement is also evalated.
umming up
'he credit ratings assigned !y ICR. are a sym!olic representation of its crrent opinion on the
relative credit risk associated #ith the instrments rated. 'his opinion is arrived at follo#ing a detailed
evalation of the isser/s !siness and financial risks and on sing sch evalation to pro-ect the level
and sta!ility of its ftre financial performance in varios likely scenarios. While several parameters
are sed to assess an NBFC/s risk profile" the relative importance of each of these parameters
(%alitative as #ell %antitative) can vary across companies" depending on its potential to change the
overall risk profile of the company concerned.
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ICRAs Credit Rating Methodology for Non-Banking
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