Nov 05, 2024

Banking & Finance 2024 – Trends & Developments

The Indian economy has been one of the few bright spots in the global financial markets, despite an uncertain and challenging global macro-economic backdrop. A key indicator is consistent growth since the beginning of FY 2021 in the country’s GDP, which has risen by an average annual rate of 8.3% driven by strong domestic demand and continued government efforts focused on reform and capital expenditure. India is poised to overtake Japan and become the fourth-largest economy in the world by FY 2025-26. The country’s financial sector, in particular, has seen significant growth; in FY 2022, the banking, financial services and insurance sectors made up 12% of GDP. We set out below certain key trends and developments in India’s financial segment.

Consolidation in the NBFC Sector

Non-banking financial companies (NBFCs) – or “shadow banks”, as they are popularly called – have long been regarded as beneficiaries of a lighter-touch regulatory regime compared to regular banks. In light of: (i) the rapid growth of the NBFC sector; (ii) this sector’s increasing inter-connection with the wider financial system; and (iii) plans to reduce regulatory arbitrage, the Reserve Bank of India (RBI) has overhauled NBFC regulation by introducing a scale-based framework aimed at governing different categories of NBFCs based on the principal of proportionality, with the NBFCs categorised into four layers – Base Layer, Middle Layer, Upper Layer (NBFC-UL), and Top Layer, according to their size, complexity and systemic importance. The Top Layer is currently empty (and is intended to be so) and is only to be utilised if the RBI is of the opinion that there is a substantial increase in the potential systemic risk from a specific NBFC within the Upper Layer.

Mandatory Listing and IPO Timetable for NBFC-ULs

Identification of NBFCs that should form part of the Upper Layer is undertaken through a rigorous analysis by the RBI that combines quantitative (70% weightage) and qualitative parameters, along with supervisory judgment (30% weightage). So far, based on this annual assessment, the RBI has released two notifications, one in 2022 and the other in 2023, with the latter identifying 15 entities as NBFC-UL on 14 September 2023. Among the enhanced regulatory requirements applicable to them, the most significant is a mandatory requirement that they go public within three years of their identification as NBFC-ULs.

Case of Regulation Driving M&A

The introduction of the scale-based regulations and, in particular, the potential mandatory listing requirement described above, has spurred consolidation and increased M&A activity in the sector. For example, many large conglomerates that had multiple NBFCs in the group have undertaken mergers with a view to creating a single, larger NBFC entity. The RBI has also supported this trend, since it achieves its wider goal of reducing the number of licensed entities within a single group. In addition, given the potential for very large NBFCs being made subject to classic-bank type regulation, there have also been some notable instances of NBFC-bank mergers, the most prominent being the mega merger of Housing Development Finance Corporation Limited into HDFC Bank Limited. The growing M&A activity across this sector is likely to continue in the coming years as more entities become classified as NBFC-ULs.

The Rise of Private Credit

The rise of private credit as an alternate to bank funding has been a global trend since the financial crisis of 2008. In India, with banks and other traditional lenders shifting their focus away from wholesale structured credit to retail and MSME financing, private credit is fast emerging as an alternative avenue for corporate fundraising. This is particularly relevant to corporate borrowers looking for a tailored solution that brings with it the flexibility to cater to business cycles and anticipated large corporate events (eg, an anticipated fund raising, IPO or acquisition). According to a 2023 report prepared by Praxis Global Alliance and Indian Venture and Alternate Capital Association, more than 55 private credit alternative investment funds (AIFs) have entered India’s private credit market in the last five years, and the assets managed by AIFs will likely total USD60-70 billion by 2028. In recent years, India’s private credit market has grown steadily, driven by both global players and domestic champions, with sectors such as real estate, manufacturing, financial services and technology the key beneficiaries. Another interesting trend has been the gradual shift over to performing credit by private credit players historically focused only on special situations/stressed assets.

Private Credit – Opportunities

The general sluggishness in corporate lending by traditional financiers has created a demand-supply gap and room for private credit players. Further, traditional financiers such as banks and NBFCs are subject to a far more prescriptive regulatory regime including, in particular, restrictions on end use. For instance, banks in India are not permitted to provide loans for the purchase of equity shares, and neither banks nor NBFCs can grant loans for the acquisition of land. Considering that these restrictions do not apply to private credit players, and that there is a growing demand for acquisition finance and land finance, this presents an important opportunity for private credit.

Three factors have now combined to create something of a gap, blank canvas, or opportunity for private credit players:

  • the trend for mutual-fund regulation by the Securities and Exchange Board of India (SEBI) over the last few years and its stance that mutual funds (an important provider of debt capital) should not engage in structured trades combined with the relative shallowness of India’s bond market;
  • the “funding winter” which made venture capital and private equity harder to come by at the lofty valuations observed in the past, as well as the reluctance of late-stage companies to engage in “down rounds”, have opened the way for private credit companies to provide structured-finance solutions which typically involve some of form of equity upside or kicker;
  • the impressive track record of returns made by private credit players has attracted significant interest from investors (including family offices) seeking diversification and solid returns. Growing demand for this alternative asset class has also ramped up the trend among private equity sponsors creating dedicated funds to focus entirely on private credit.

Private Credit – Risks

While the private credit market in India continues to look promising, the RBI has also recognised that this expanding segment does nonetheless carry significant risks, as follows:

  • riskier borrowers than counterparts in traditional lending spaces;
  • possible large capital losses for investors, particularly insurance companies and pension funds, with systemic implications;
  • higher liquidity risks due to growing retail presence and higher redemption rights;
  • interconnectedness with other segments of the financial system;
  • presence of data gaps which pose a challenge in monitoring developments in the private credit market; and
  • private credit is yet to be tested in a credit cycle downturn, and sharp losses could lead to a loss of confidence in the asset class as a whole.

A major risk to the sector would be regulators in India seeking to govern private credit players in the same way as traditional financiers. There has in fact already been some regulatory action by both the RBI and the SEBI concerning structures perceived to be methods to “evergreen” loans, detailed below.

AIFs – evergreening of loans and circumvention of FX regulations

An AIF in India is a privately pooled investment vehicle that is registered with and regulated by the SEBI. In comparison to certain other SEBI- regulated entities, such as mutual funds, AIFs have a light-touch regulatory framework for which they have gained prominence in the debt market.

However, concerns have been raised by the SEBI and the RBI over AIFs being structured in such a way as to circumvent banking and foreign direct investment (FDI) regulations, including inter alia evergreening of loans extended by entities regulated by the RBI – ie, banks and NBFCs (Regulated Entities and circumvention of FDI guidelines. The SEBI has noted over 40 cases involving more than INR300 billion in funds where transactions may have been structured through AIFs to circumvent financial-sector regulations.

Also, under the FDI regime, a downstream investment by an AIF (even if a majority of its investors are non-resident) in an Indian entity is not considered indirect foreign investment so long as both the investment manager and the sponsor of the AIF are resident Indian entities. While intended to promote inflow of investments from a large number of non-residents in AIFs, in some cases such investment has been misused by entities to bypass: (i) certain key requirements under the FDI regime, such as pricing guidelines and sectoral limits; and (ii) conditions applicable to external commercial borrowing, foreign venture capital investment and foreign portfolio investment methods (ie, the available debt entry routes for non-residents).

Evolving regulatory regime on evergreening by AIFs

Against this backdrop, the RBI and SEBI issued amendments to the existing framework to tighten up any loose ends.

In December 2023, the RBI prohibited Regulated Entities from making investments in AIFs having direct/indirect downstream investments in a company to which such Regulated Entity has/had a loan or investment exposure during the preceding 12 months (Debtor Company). Further, if an AIF scheme having investment from a Regulated Entity makes any downstream investment in a Debtor Company then the Regulated Entity is required to liquidate its investment in the scheme within 30 days of the downstream investment. Any existing investments by a Regulated Entity in an AIF scheme that has such investments in a Debtor Company (of the Regulated Entity) were required to be liquidated by the Regulated Entity within 30 days from the issuance of directions failing which the Regulated Entity was required to make a 100% provision on such investments.

Initially, at least six Indian banks had made a combined provision of over INR 10.7 billion, which indicates that certain Regulated Entities preferred making provisions instead of liquidating the investments in the schemes. One reason for this could be the lack of a robust secondary market for sale of AIF units.

Pursuant to the outcry by many of the stakeholders, the RBI, in another circular issued in March 2024, clarified that Regulated Entities are required to make provisions only to the extent of their investment in the AIF, which has been invested by the AIF in the Debtor Company (as opposed to the Regulated Entity provisioning for the entire investment made by the Regulated Entity in the AIF). Relying on the clarifications, certain banks wrote back INR4.57 billion from the provisions they had earlier made for their investments in the AIFs.

In a similar vein, SEBI amended the AIF regulations to place an onus on the investment manager of an AIF and the key managing personnel of the AIF and its investment manager to conduct specific due diligence on the investors, as well as the portfolio investments by the AIF, to prevent circumvention of applicable laws including the RBI and FDI guidelines. The SEBI has also stated that specific implementation standards in relation to these due diligence requirements will be formulated by the pilot industry standard forum for AIFs in consultation with itself. The standards in question aim to prevent AIFs from arriving at unintended interpretations of the requirements.

Banking in GIFT City

In 2019, India set up International Financial Services Centre (IFSC), Gujarat International Finance Tec-City (GIFT City) to serve as a global financial hub and to create units to provide offshore banking services. While situated in India, for foreign exchange law purposes, GIFT City is construed as being a territory outside India.

The regulatory framework applicable to IFSC units (including International Banking Units (IBUs) provides numerous incentives for banks to set up shop in GIFT City, including tax breaks and a unified regulatory framework administered by a single regulator. GIFT City provides a very competitive tax regime pertaining to both direct and indirect taxation. The units in GIFT City have a 100% tax exemption for ten (out of 15) consecutive years. Relaxations have also been extended in relation to maintenance of regulatory capital. So far, 28 banks have set up branches, including five of the top ten global banks and top ten Indian banks.

The differential tax treatment and, in particular, the non-applicability of withholding taxes when making payment of interest to a GIFT City lender has led to borrowers preferring GIFT City lenders for their financing requirements. As a result, there has been: (i) an uptick in the number of external commercial borrowings being obtained from the GIFT City branches of banks; (ii) a rush among foreign banks not already present in GIFT City to set up there; and (iii) transfer of existing commercial borrowings by foreign banks to their GIFT City branches to benefit from the lack of withholding tax on interest payments. In just two years, there has been a surge of 180% in the loan exposure of IBUs. GIFT City IBUs had extended loans of almost USD52 billion as of 31 December 2023 versus USD18 billion as of 31 March 2022.

Digitisation of Financial Services

Given India’s demographics, large total addressable market, the under-penetration of its financial services and its world-class digital public infrastructure, the financial services industry there is poised to continue to attract significant interest.

India Stack

  • JAM: The Government of India’s initiatives popularly known as “JAM Trinity” is a combination of: (i) the Jan Dhan (Pradhan Mantri Jan Dhan Yojana), a financial inclusion programme which led to a widescale opening of bank accounts and the inclusion of millions of unbanked individuals into the banking system; (ii) Aadhaar, a biometric identification system which has penetrated over 93% of India’s 1.4 billion population (as of May 2023); and (iii) Mobile, ie, the availability of affordable smart phones and access to data which has led to a sharp increase in internet users – mobile-based internet users in India totalled 0.9 billion in May 2024.
  • Unified Payment Interface (UPI): this is India’s fast payment system for peer-to-peer and peer-to-merchant transactions. Since its introduction in 2016, UPI has seen widescale adoption resulting in India overtaking China as the country with the highest number of digital transactions. The number of transactions in India in FY 2023-24 stood at 185 billion.
  • Unified Lending Interface (ULI): ULI is the latest digital public product announced by the RBI which will commence with a pilot technology platform for seamless and frictionless delivery of credit, including technology-supported fetching of data, credit underwriting, etc.

In a recent speech, the RBI’s governor heralded JAM, UPI and ULI as the new trinity that will mark a revolutionary step forward in India’s digital public infrastructure journey.

Banks Want to be Fintechs Who Wants to Be Banks

Banks, which have traditionally been focused on brick-and-mortar distribution and expansion, have come to realise the importance of technological innovation, investments in technology and utilising India Stack in the delivery of their services. In many cases, they have undergone transformational changes to become banks with a “digital first” mindset.

While this change has, in part, been driven by the traditional banks’ fear of fierce competition from the new-age fintech players, an emerging trend today is intense collaboration between banks and fintechs with a view to leveraging their respective strengths.

Correspondingly, there is also a rising trend for mature fintechs seeking to set up or acquire licensed entities with a view to themselves carrying on financial services business as opposed to distribution only.

Conclusion

The banking and finance sector in India remains an exciting and evolving space with a large total addressable market, a firm but progressive regulator and world-beating digital public infrastructure. We expect it to continue to attract significant interest from major domestic and global players and growth momentum to endure.

AUTHORS & CONTRIBUTORS

TAGS

SHARE

DISCLAIMER

These are the views and opinions of the author(s) and do not necessarily reflect the views of the Firm. This article is intended for general information only and does not constitute legal or other advice and you acknowledge that there is no relationship (implied, legal or fiduciary) between you and the author/AZB. AZB does not claim that the article's content or information is accurate, correct or complete, and disclaims all liability for any loss or damage caused through error or omission.