Lending businesses are fascinating. In any other business, the scale at which it operates depends upon the capital its owners has invested in the first place. Although it can borrow can get some extra scale, its ability to do so is very much limited to say 1-3x of equity capital. And higher its debt gets, lower goes its ability to attract further funds.

And then you see the financials of a bank or a non-banking financial company (NBFC). For these, every rupee of capital enables them to do business (i.e. lending) worth Rs 8-10. They get to borrow funds at nominal cost in form of deposits (savings account / FD) from lay investors who are hardly even aware about the risks involved.

How many account holders even care to see the leverage at which a particular bank is operating? A look at SBI’s leverage can make any sane individual sweat but that doesn’t explain why is it the largest bank in the country. Especially when it comes to mobilizing deposits.

So, their ability to mobilize funds from unsuspecting public at rates less than that of of inflation is an advantage. And so is their ability to lend in a country like India where bond markets, unlike equity markets, are very much restricted in their operations.

Add to these the fact that each of these require an approval from the regulator before starting up their operations and voila – you get a sector wherein number of players and hence the competition in the market is relatively limited (versus say that in cement or steel which has virtually zero barriers to entry)

All of this in a country which has one of the lowest penetration of debt in the world and whose appetite for credit is growing at a healthy rate over the years. What else can one ask for! But off late, things doesn’t look as rosy as it should be for these companies. So, what’s the catch?

The basic economics

Leverage is toxic in nature.

If a bank writes loans worth Rs 100 in a given year, it just requires loans worth Rs 10 to go bad for it to be declared ‘bankrupt’. This is because its networth is tiny versus those loans.

Its business is essentially that of borrowing Rs 90 at attractive rates, and along with it own capital of Rs 10, lend Rs 100 at lucrative rates. From the differential spread, pay for its operating expenses and take home the balance left over as profits.

It’s far different from an arbitrage. That is because if its borrowers find it difficult to service back a portion of that Rs 100, it has to swallow all of those losses on its own. There is no ‘pass-through’ of the same to its lenders or deposit holders.

Good Bank vs Bad Bank

So, what is required to be successful in this business? As prospective owners, this is a question which one needs to frequently answer while evaluating any business. In case of these lending companies, these are:

(i) Ability to timely recover almost all of the money which is being lent along with the interest amount: 

Remember the leverage involved here is huge and there is no pass through. If you couldn’t recover even say 3% of your loan book, you loose 30% of your networth. Hardly worth those narrow spreads!

Look like a ‘too big to meet’ kind of a hurdle, right? True. But then there those rare lenders which have been able to do this consistently over last 2-3 decades. Studying their lending focus areas can help us uncover some of the key success factors here.

  • Lend more to individuals to the extent of their earning power. Recovery rates here are surprisingly good. No one wants their CIBIL score to deteriorate due to a missed car or home loan EMI. This is provided you have been judiciously lent i.e. within their earnings ability.
  • In case of corporate loans there are two things to take care of – lending to good quality corporates and keeping your maturities short. While the former is self explanatory but in case of the latter generally it is observed that, lower the loan tenure, higher is the ability to recover your amount. Hence, lending for working capital requirements and other short maturities triumphs longer tenure loans. This does way the risks involved with lending to under construction projects which ultimately may or may not fly.
  • Have a sticky relationship so although tenure may be shorter, it is almost seamlessly renewed thereby doing away with screening for newer borrowers just to replenish existing bucket. Thereby keeping operating costs under control.
  • Doing secured lending (‘good quality corporates’). And this in no way is restricted to tangible assets (though having this with low loan to value ratio is good) but also the size of cash operating cash flows which the borrower generates. Security in form of ‘earnings’ could add a lot of comfort. Some lenders charge rates of unsecured loans (18%+) whose earnings, in their assessment, are very much secured!
  • Lending at competitive rates with industry leading shorter processing times.

(ii) Having the lowest operating cost structure (interest as well as non-interest costs): Remember, banks are spread earners. So, one way to maximize this spread is to lower your costs i.e. interest cost and operating expenses.

Interest costs could be lowered by having higher portion of borrowed funds coming from lower interest sources. So, higher the contribution from current account (close to 0%) and savings accounts (~3.5%), the better it is. And these are more sticky in nature. People do not frequently move their saving account balances from one place to another even if it is marginally higher.

Another area to improve your cost structure is to have a ‘cross-selling’ strategy in place i.e. your branches are able to sell more and more types of products to the same set of customers. That is like selling your savings account holder your credit card service, insurance products, mutual fund products, brokerage products, home loans, personal loans, etc.

If it is a single segment focused NBFC which cannot do cross-selling functions than achieving an ability to deliver your services in quickest possible time with lowest possible cost should compensate. Or your average yields (interest income) and asset quality need to good enough in order to make the model viable. But remember, higher yields and better asset quality rarely goes hand in hand. More on this later.

Positive Feedback Loop

This is where it get even more interesting. Recall that, in any lending business, there is this function of 3 key elements. Interest Income (-) Interest Cost = Profit Spread.

This profit spread needs to be high enough to provide for (i) employee salaries (ii) provide for bad debts and (iii) ultimate profits to owners.

In this equation, it is the point (ii) that is, magnitude of bad debts, which is like the joker in the pack. It has the highest impact on ultimate networth of the bank and, unfortunately, it is also the one which is highly uncertain. Especially if the bank in question is doing more project finance of longer tenure.

But for those few lenders which can keep their operating costs (interest & non-interest costs) low while maintaining impeccable lending discipline are able to earn good enough spreads even while dealing in low yielding, low risk segments. And these are precisely those segments where your asset quality is the best.

And what is more important is their competition is here even more limited. All those lenders who find their interest and other costs higher will find it difficult to break into the lending segments in which an efficient bank operates.

So, for a newer entrant with a relative cost dis-advantage (i.e. lack of lower interest savings account), it has to invariably break into higher risk, higher yielding segment. And it is those risks which are more uncertain here than what a top tier (in terms of cost efficiency) lender takes up. For us as owners it means that we need to quite weary about the sustainability of its networth figure. More so if its borrower base is concentrated enough.

So by keeping your costs low (interest as well as non-interest), a lender can operate in low risk segments thereby considerably lowering the uncertainty involved with respect to asset quality and ultimately shareholder’s networth.

The good thing here is that cost advantages here are structural and not easy for newer entrants to replicate even if they have zero issues on asset quality in the initial loan book building period.

Though PSU banks, despite having a higher composition of low cost funds (savings account balances), lost out to private banks over the last 2-3 decades. But the reason here was their inability to maintain their asset quality. This makes it difficult to maintain their market share during stressful times.

Had the government not infused funds into these from time to time, most of them would have been dead by now!

Its a rare combination to have a competitive cost structure with an impressive asset quality maintained consistently at all times. And this is where our focus should be as prospective owners.

This means that out of those dozens of listed lending companies out there, our hunting ground is restricted to just 3 or 5 companies. This isn’t necessarily a bad situation.

Also, it is our job to remain vigilant that these good quality lender and not drifting away from their earlier established lending practices. That could be done by looking for aggressive lending practices like higher loan to value ratio, project finance, longer duration loans and the likes.

It is finally our funds – in form of that tiny networth – which is at stake.

The positive feedback loop operates well on its own unless it is being interfered. Which in this case would be a significant deterioration in lending metrics.