Banking and NBFC business in India
For any economy, banks and financial institutions form a backbone and perform the very important task of lending to businesses and individuals. For a credit business to make money, it needs a strong foundation on three main pillars
1. Ability to find credit worthy customers to provide loans
2. Ability to raise money to fund these loans
3. Ability to recover the loans (principal + Interest)
If you look at any bank or NBFC in India to understand its competitive strength (or moat), you will see the moat lies in the combination of these three pillars.
A bank needs ethical, focused and disciplined management to protect and strengthen these pillars. It takes discipline and courage to walk away from business if it qualitatively and quantitatively weakens these pillars. Easier said than done, and so we find many banks/NBFC’s burdened with bad quality assets, low NIM (Net Interest Margin) and very high NPA (Non-Performing Assets)
Why is the housing finance segment so attractive for Indian banks/NBFCs?
According to research reports, the current housing shortage in rural India is 40 million and urban India is 19 million houses. This shortage will creep up in future with rapid urbanisation, nuclearization of families, creation of new cities and people’s aspiration to have better homes and lifestyle.
Housing finance business is perceived to be a simple business. You raise capital, find couple of aspiring homeowners to finance a home backed by salary income and keep the financed house as collateral. With conservative LTV (Loan-to-Value) and increasing asset prices, you can hardly run a risk of bad loan. The borrower would default on its house (valuable asset) as a last resort. At least it sounds simple.
Safe risk spectrum and rising demand makes it very attractive for most financing companies, but the same proposition also makes this business very competitive. Almost every national or regional bank is active in this segment. Apart from the organised banking sector, there are thousands of individual lenders especially in semi-urban and rural segment milking aspiring homeowners.
Size and structure of housing finance market
As of June 2014, the outstanding home loan book stood at INR11 trillion. Top 5 players (SBI, LIC, HDFC, ICICI and Axis Bank) command 56% of the market share.
Various reports suggest different growth rates for this segment but one can conservatively estimate the growth to be at least couple of percentage points above GDP rate.
Most companies operate in urban market and target HIG (Higher Income Group) with large loan ticket for obvious reasons. It is lucrative to find a cow that gives 10L of milk/day versus 10 cows with 1L of milk/day, even though the risk of one dead cow translates into 100% loss of business in former case vs. 10% in latter case. No wonder that many banks are sitting on high NPA it their attempt to milk fat corporate cows.
Most companies target salaried professionals because it is easier to do credit assessment for such borrowers. It is similar to investing only in well-known companies than to make an effort of researching smaller companies without widely available information. However self-employed comprises of 50% of the total workforce in India.
Repco Home Finance (RHF)
Among the many players in home financing, one of the smaller player is Repco Home Finance.
Lets go back to the three pillars we talked about before and understand if it provides any competitive advantage to Repco Home Finance
1. Ability to find good credit worthy customers to provide loans – Repco Home Finance focuses on:
- Providing loans to segments underserved by larger housing finance companies and banks.
- Providing loans to mainly self-employed professionals and self-employed non-professionals.
- Tier-2/3 cities and peripheries of Tier-1 cities.
Why is this segment interesting? As stated before, self-employed comprises about half of the total working population.
So why is this segment under-served? Banks like to feed the elephants rather than little ants. They like to feed the HIG (High Income Group) who can take a large loans rather than feeding hundreds of borrowers with small loans. Secondly serving the self-employed borrowers calls for lot more work in credit assessment.
Hence this segment is currently served (or rather exploited) by individual lenders who charge extremely high rates and have no tolerance for slippages in repayments.
Enter Repco Home Finance – it provides a structured alternative to this group of underserved borrowers. Its focus on underserved market also greater provides greater pricing power to the company.
This is all fine, but how does it provide any sustainable competitive advantage to Repco?
a. The real moat here is credit assessment of self-employed people who do not have standard documents such as tax returns, salary slips, accounts of business etc. The interest rates are based on credit score and loan amount is based on LTV (Loan-to-Value). As they continue to serve the self-employed from various different industries and background, they are able to create credit assessment models which will take years for competition to replicate.
Stringent risk management controls delinquencies. Same person is responsible for origination, appraisal, monitoring and recovery of the loan and his/her compensation is tied not only to origination but also to timely recovery of the loan. This risk management process indirectly puts constraint on the company to grow very quickly due to shortage of trained man power as it takes more than 6 months to train a employee.
b. The second moat is network effect – as the company goes deeper into Tier-2 and Tier-3 cities they are building reputation as the only alternative to individual lenders who charge much higher rates. As the company assesses the credit worthiness of the borrower by speaking to its neighbours, landlords, customers, suppliers etc. they are indirectly able to spread the awareness about Repco Home finance business.
2. Ability to raise money to fund these loans – Repco Home Finance has traditionally borrowed money from conventional sources such as NHB and Banks. More recently Repco has started to diversify its funding by issuing Commercial papers and Non-convertible debentures.
With interest rates going down and diversified source of funding, its cost of funding will go down but the yields may hold up, providing higher spreads and NIM. Even though Repco can keep the lending rates high, the ethical and sensible business practice will be to keep the spreads at normalised levels by passing the lower interest rate benefits to customers. This will also keep competition at bay.
3. Ability to recover the loans (principal + interest) – The ability to recover loans is tied with the first principle of ability to find credit worthy borrowers. You will find countless examples of banks going under the water due to bad lending practice. As they say “You only find out who is swimming naked when the tides goes out”
In case of Repco Home Finance, it becomes even more critical to look at the quality of the loan book and NPA because it serves the unconventional self-employed category.
Now for a moment let us think from the vantage point of a borrower –
I run a small business and I’ve been working hard for years to provide food, shelter and clothing for my family. I now have enough savings to put down initial down payment (50% of the value) to buy a house. Apart from a having a house of mine it will also be my tangible hard asset. My earnings are lumpy as I make most of my money only for few months but I’m confident to be able to pay my instalments, as the instalment value is less than 50% of my income. If things get worst, I’ll cut down on other expenses but make sure to pay my instalment as this house is my appreciating asset and I’ll not give away my asset. In fact I want to work hard to get this loan off my back as soon as possible.
Repco lends to such aspiring home owners who put up more than 50% of the value of the house up front. They will give up their assets only as a last resort when they have given up everything else. However given the seasonality of their earnings they might fall behind in instalment repayment schedule but will make up as soon as the earnings pick up. This seasonality is obvious from the quarterly NPA movements of Repco.
Loans written off since inception is just 4.3cr which is 0.06% of total cumulative disbursements proves the point that borrowers would not easily default on their asset.
But what happens if there is a serious property crisis and house prices fall sharply? Indian housing market is not highly levered. Mortgage to GDP is just 9%, meaning borrowers do not take leverage to “invest in property”. These rural and semi-urban borrowers buy houses for dwelling and not investment. Secondly the LTV is around 50% unlike the mortgage situation in the west where banks lend the full value of the house plus more.
Repco borrowers will not suddenly vacate the house and default because the prices have fallen sharply. Such crisis mainly impacts borrowers who are leveraging up to buy expensive urban properties as an investment which is not the target client of Repco.
Repco is trying to provide further comfort by making higher provisions for NPA, but that will naturally have an impact on the profitability of the company
Other Important Points
One can look at other metrics such as geographical presence, branch expansion, cost-to-income ratio, OPEX/branch, management quality, Capital adequacy ratio etc. to get further insights about the company. Those metrics are only building blocks on a strong foundation, but the key is to focus on the three key pillars highlighted before.
Future of the company
Most financial companies are evaluated on the basis of Price-to-Book ratio, Return on Equity, Return on Assets etc. but one needs to look beyond these textbook methodologies to understand and evaluate certain businesses. One needs to apply different mental models for evaluating different businesses.
India is a growing economy with a major part of population going into working class soon. These people will need three basic things in life – food, clothing and shelter. Though property prices have been going up, house affordability is increasing as well and ownership of a house continues to be a life long dream of every Indian.
If we just look at the current shortage of houses and the fact that Repco is currently has only 57500 accounts will give you an idea of opportunity ahead. One also needs to keep in mind that Repco has been able to grow the loan book at 35% CAGR from 2009-2014 when the Indian economy was at its worst, so Repco should certainly do better in good times.
Government initiatives such as Housing for all by 2022, tax breaks, lower risk weights and CAR etc. will provide further tailwind to this sector but that should not be the premise of any investment.
I do not want to extrapolate the numbers based on expected growth rates in loan book, ROE, book value etc. to derive at intrinsic value of the business because good businesses cannot be deduced to few textbook variables.
- Economy downturn and substantial increase in interest rates
- Regulatory changes that may put housing finance companies at competitive disadvantage
- Deterioration in risk management and credit appraisal quality in its quest to grow very quickly
Disclosure: The article reflects my personal thoughts on the company and is not a recommendation to buy or sell the security. I’m an investor in Repco Home Finance.