Risk Assessment and Mitigation: A Strategic Approach to NBFC Due Diligence

In the ever-changing financial industry, due diligence is crucial, and it will become much more crucial when interacting with non-banking financial companies (NBFCs). Non-banking financial companies (NBFCs), which provide a range of financial services, are vital to the economy. But because of their unique characteristics, they also come with certain hazards, so you have to be extra cautious and aware.

A lack of proper due diligence on non-bank financial companies (NBFCs) can expose stakeholders to a number of risks, such as operational inefficiencies, regulatory noncompliance, and unstable finances. These risks suggest that there is a good chance that the financial markets will be shaken, investor confidence will be damaged, and there will be large losses. By providing a systematic means of assessing an NBFCs operational stability, financial balance, and regulatory compliance, a thorough due diligence process acts as a safeguard against these risks.

This blog will go into great detail regarding the procedural elements of doing due diligence on non-financial institution monetary groupings (NBFCs) in order to provide readers the knowledge they need to make informed decisions and protect the integrity of the financial system.

What is a non-banking financial company, or NBFC?

A financial business that was established in accordance with the Companies Act of 1956 and 2013 is considered non-banking. Among its activities include lending, advances, buying shares, leasing, hire-purchase, insurance, and chit trading. In accordance with Reserve Bank of India Act, 1934 section 45-IA, it is also required for an NBFC.

Non-banking monetary agencies are financial businesses that offer services similar to those of traditional banks but operate independently of the established banking equipment. Non-banking financial companies, or NBFCs, offer insurance, advances, loans, and stock purchases but are not permitted to conduct banking operations in the same way that banks are. Non-bank financial companies (NBFCs) have been divided into several sorts due to their varied duties, with each type concentrating on offering unique financial solutions.

• Asset Finance Companies (NBFCs): These companies frequently assist in financing the acquisition of particular assets, such as machinery, cars, or other goods.
• Loan Companies: These non-financial institutions (NBFCs), which concentrate on lending and advances, are vital in giving credit ratings to people and businesses.
• Investment Companies: NBFCs in this category frequently engage with securities investments and offer services related to capital market activity.

Establishing Regulatory Framework

Ensuring economic equilibrium, safeguarding depositor interests, and upholding the integrity of the monetary system all depend on strict regulatory control of NBFC operations. Key authorities often conduct regulatory monitoring, and at some stage in the due diligence process, adherence to their requirements becomes critical.

• India’s Reserve Bank (RBI): The RBI is the major regulatory body in charge of monitoring and managing NBFCs. Following RBI guidelines is crucial for NBFCs to function efficiently.
• The Securities and Exchange Board of India, or SEBI: SEBI laws apply to NBFCs that conduct capital market and securities-related activities. This entails adhering to disclosure laws and indicators of market conduct.
• Other Regulating Authorities: Compliance with other regulatory organisations, such as the National Home Bank (NHB), may also be required for home finance NBFCs, contingent upon the unique characteristics of the NBFC.

Legal compliances should be examined for NBFC Due Diligence

To perform NBFC Due Diligence, the auditor needs to confirm the following legal compliances.

The Creation of Statutory Reserves

As stated in the profit and loss statement and before any dividend declaration, every Non-Bank Financial Corporation (NBFC) must create a reserve fund and transfer at least twenty percent of its yearly net profit, as mandated by section 45-IC of the Reserve Bank of India Act, 1934.

NBFC enrolment using the KYC website

Every NBFC is expected to register on the KYC website and submit the necessary information.

1. Enrolment in the Financial Intelligence Unit – India (FIU-Ind): The Non-Bank Financial Companies (NBFCs) are mandated by the Prevention of Money Laundering Act, 2002 and its implementing regulations to verify the identity of their clients, maintain documentation, and furnish data to the Financial Intelligence Unit – India.
2. Appointment of Nominated Counsel at Delhi High Court: According to a SEBI guidance note, all NBFCs with the authority to invoke Sections 13 and 14 of the SARFAESI Act must designate counsel in the High Court and forward their names to the Central Registry of Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest.
3. Obtain membership in a Credit Information Company (CIC): As per RBI regulations, all Non-Bank Financial Companies (NBFCs) must needs to join one of the four CICs.
4. Auditor’s Report to Directors and Statutory Auditor Certificate: In accordance with RBI Circular No. Various, it is necessary to conduct a due diligence examination of the auditor’s report and statutory auditor certificate.

Objectives

Before starting the due diligence process for a non-banking financial organisation (NBFC), it is imperative to set certain goals. The method’s compass, which guarantees that the evaluation is thorough and in line with the stakeholders’ strategic objectives, satisfies these demands. Generally, the following are the main objectives:

• Analysing Financial Stability: To ensure that the NBFC can continue operations and fulfil its responsibilities, it is essential to evaluate its economic balance, liquidity, and solvency.
• Ensuring Conformity to requirements: Preventing criminal and compliance risks related to the NBFCs activities by guaranteeing compliance with regulatory requirements.
• Operational Efficiency Analysis: The NBFC will evaluate its internal strategy, risk management practices, and average operational efficiency in order to identify areas that need improvement and possible operational hazards.

Obtaining Information

Gathering applicable records on the NBFC is step one in accomplishing effective due diligence. These fundamental facts aid in setting the stage for a more thorough investigation later on in the due diligence process. It is crucial to collect the following information:

• Finance Statements: Obtain further economic statements including the cash flow, profit, and balance sheets of the NBFC. You may better comprehend this information by looking at profitability, financial performance, and overall financial health.
• Regulatory Files: Examine regulatory files submitted to regulatory organisations like the Reserve Bank of India (RBI) to confirm compliance with criminal and regulatory norms.
• organisational Structure: Name the main decision-makers, the organisational structure, and the operational framework of the NBFC. Assessing possible conflicts of interest and governance is much easier with this understanding.

Due Diligence in Finance 

1. Examination of Financial Accounts:

One of the most important tasks in financial due diligence is reviewing the financial statements of a Non-Banking Financial Company (NBFC). The balance sheet, profits release, and coins flow declaration are the three primary financial statements that might undergo a thorough examination at any stage of the procedure.

Examine the NBFC’s fairness, obligations, and assets in relation to the balance sheet. Take note of how assets allocation takes place—loans and investments—and liabilities—debt and obligations. Evaluate the leverage and liquidity of the organisation.

2. Evaluation of Debt and Equity:

• Asset Quality: Examine the assortment of assets, paying special attention to the loans and investments. Check the loan portfolio’s credit score quality and the danger of using numerous asset instructions.
• Structure of Responsibilities: Consider the many types of debts, responsibilities, and liabilities. Analyse the agency’s obligations’ maturity profile to see if it can carry out its duties for a longer period of time.

3. Assessment of Monetary Performance;

Based on its past financial performance, one might infer the NBFCs upward trajectory and durability.

• Profitability Trends: Track variations in return on equity and net profits margin over time. A robust financial system is viewable by consistent economic performance.
• Trends in Solvency and Liquidity: Evaluate how these ratios have changed over time. It is simpler to project future financial health when it detects the patterns, as they may either improve or worsen.

Due Diligence in operations

Evaluation of the Business Model:

This part of the website offers a thorough rundown of the primary duties and funding sources of the NBFC. It demonstrates how lending, investing, and other financial services are how the NBFC makes money. To make sure that its operations align with its lofty objectives and aspirations, it is important to evaluate how well the business model complements the employer’s entire strategy.

Examining the Target Market:

To properly comprehend the target market study, a thorough examination of the NBFCs client businesses and geographic reach are must. It may be possible to gain insight into the NBFCs market positioning by examining the demand for financial products and services within these headings. The operational sustainability of an NBFC depends on its ability to meet the needs of its target market and adjust to the evolving choices of its customers.

Establishing a Competitive Advantage:

It is crucial to assess the NBFC’s reputation within the sector. Analysing differentiation strategies, competitive advantages, and unique marketing components are all part of this. Stakeholders can evaluate the NBFC’s aggressive energy and prospects for market development by understanding what makes it different from rivals.

An assessment of sustainability:

An in-depth analysis of market trends, financial arguments, and regulatory dynamics is necessary to determine the viability of the NBFCs commercial business model. Examining creative market trends can help identify the NBFCs resilience to economic ups and downs. By taking into account the effects of all recent and upcoming regulatory changes, its ability to manage the changing regulatory landscape may be guaranteed.

Strategies for Risk Management

• Credit Risk Assessment and Management: This involves researching the NBFCs methods for identifying and managing credit risks. An analysis of mortgage excellence, underwriting guidelines, and provisioning tactics provides insight into the NBFC’s capacity to oversee its mortgage portfolio and control credit score-related risks.
• Market Risk Management: It is crucial to evaluate the NBFCs strategy for controlling market risks in addition to transferring hobby rates and asset values. The degree to which the NBFC defines can withstand shifts in the external economic markets by the efficacy of its threat-hedging tactics and solutions against market uncertainty.
• Operational Risk Management: In order to guarantee operational resilience, consider the NBFC’s methods for recognising, contrasting, and reducing operational hazards. This involves assessing internal strategies, technological developments, and human issues that might provide operational difficulties. It is critical to comprehend the NBFC’s danger management techniques in order to guarantee business continuation.
• The efficacy of threat mitigation strategies: An essential first stage in determining the effectiveness of the NBFCs danger reduction techniques is to evaluate their compliance with business fine and felony procedures. This ensures that the NBFC is protecting its business by using sensible safeguards.
• Monitoring and Reports: It is critical to assess the threat-tracking mechanisms of the NBFC promptly. The NBFCs ability to quickly disclose and address emerging risks enhances its risk management skills. This transparency is essential for stakeholder decision-making.