Mediating effects of funding strategies and profit maximization: Indian non‐banking finance sector

AuthorG. Thiyagarajan, A. Arulraj
Publication Date13 Jan 2012
Mediating effects of funding strategies and
profit maximization: Indian non-banking
finance sector
G. Thiyagarajan and A. Arulraj
Purpose – The mobilization of funds was severely affected with the linking of their funds mobilization to
their internal owned funds. Therefore, the purpose of the study is to identify the mediating effects of
funds with profitability and to focus on the funding strategy to maximize profits in the non-banking
financial sector in India.
Design/methodology/approach – The paper discusses various approaches to maximize profits. The
study also examines trends in sources of funds using key financial variables. A formative model to
capture the mediating effects of funds with profitability is tested using structural equation modeling
(SEM) technique. The paper includes various financial variables including external and internal funds.
These variables’ relationship with the core operating profit is tested in a graphical structural equation
environment using package software.
Findings – Mediating effects of borrowings with profitability are established. The paper concludes that
the gap in funds can be matched effectively through mobilization of funds of short duration. The study
establishes that a combination of fund raising strategies such as flotation of debentures, bank
borrowings and short term funding program can affect profits.
Research limitations/implications The study is confined to non-bank finance companies in a
particular state in India. The geographical and demographical differences may affect generalization.
However, care has been taken to match the geographical and demographical characteristics of the
Originality/value – The findings of this paper are of immense value for industry managers, lenders and
for financial forecasting within the sector.New entrepreneurs can use the findings in their funding plans.
Keywords Non-banking financial sector, Internal owned funds, Mediating effects,
Structural equation modelling, Core operating profit, Financing, India, Profit maximization
Paper type Research paper
I. Introduction
In 1961, the Non-Banking Finance Companies (NBFCs) in India were brought into a loose yet
legalized regulatory framework from a largely unregulated framework. The regulation of
these institutions was found to be necessary for ensuring efficacy of credit and monetary
policy,safeguarding depositors’ interests and ensuring the healthy growth of this sector. The
government constituted various committees to suggest the regulatory framework for the
non-banking financial sector. The Bhabatosh Datta Study Group, James Raj Study Group,
Chakravarthy Committee and Narashimham Committee (Narashimam, 1991) were the
important committees to suggest transformation of unregulated non-banking financial sector
into regulated one. The inherent strengths of NBFCs, such as high-level customer contact
and satisfaction, geographical proximity, and a strong recovery mechanism, were the
drivers of their performance. Higher rates of interest on deposits offered by them afforded a
better opportunity of channelizing domestic savings into the financial markets (Ingres,
2006). NBFCs had, practically, not been subjected to entry barriers, limitations on fixed
DOI 10.1108/15587891211191029 VOL. 6 NO. 1 2012, pp. 43-59, QEmerald Group Publishing Limited, ISSN 1558-7894
G. Thiyagarajan is Chief
Executive, Reserve Bank
Employees Cooperative
Bank, Chennai, India. A.
Arulraj is Assistant
Professor in the Department
of Economics, RS
Government College,
Thanjavur, India.
Received: 5 September 2009
Accepted: 17 March 2010
assets and holding inventories in the form of gilt investments as they are now (Thiyagarajan
and Arulraj, 2005, 2009). Moreover, the NBFCs are in a consolidation phase now.
As the financial stability was threatened with many of the NBFCs offering unimaginable rates
of interest of public deposits, their financial viability was adversely affected because of
unrestricted lending even in the case of group exposure. The Narashimam committee on
banking sector reforms (Narashimam, 1991) suggested the guidelines for the banking
system should be extended to bring the non-banking finance companies within the ambit of
an effective regulatory framework. Khanna Committee and Vasudev Committee have
recommended exclusive regulatory framework for these companies such as mandatory
registration, capital adequacy, linking of net owned funds to deposits and application of
prudential asset classification and income recognition norms. Non-Banking Financial
Companies are reclassified broadly as Asset Finance Companies, Loan Companies and
Investment Companies (Reserve Bank of India, 2006).
With the application of the tighter regulations through Reserve Bank of India Directions 1998
(applicable to NBFCs); the advantages enjoyed by NBFCs vis-a
`-vis banks have eroded
(Khan, 2002). The purpose of the paper is to focus on the trends in funds mobilization and to
identify the relationships among various types of funds and profitability of Asset Finance
Companies (AFC, Equipment and Leasing NBFCs). Further from the literature, it is
discernible that the NBFCs have started feeling the heat in the form of increased
competition. In order to ward off the competition, they have been resorting to innovation in
lending, diversification and exploration of new markets. From various studies published by
the Reserve Bank of India (RBI), it is clear that the regulations have affected the financial
strength of the non-banking finance sector with many smaller finance companies, have
wound up their activities or merged with viable non-bank finance companies. Kim and
Santomero (1988) and Kendall and Levonian (1992) have examined how the design of
risk-based capital standards influences bank risk taking. Risk taking behavior influences the
strategies to fund assets of banks, long-term costly funds are mobilized when profitability
through high cost earning assets are in product mix. Public deposits are the easy yet costly
source of financing to meet lending requirements.
Hence, the paper focuses on the key sources of funds and the mediating role played by
short-term funds. The authors feel that it is necessary to develop a sound model to identify
the mediational role played by short-term funds. In the succeeding sections, the paper will
present the emerging trends in funds mobilization, the data, methodology employed, and
finally structural equation model to capture mediating effects.
II. Literature review
A – funds mobilization strategies
Capital management refers to balancing the level of capital in such a manner that growth of
assets and liabilities is sustainable without eroding public confidence or profitability. Sinkey
(1992) uses Hempel and Yawitz’s (1977) framework to arrive at a similar formative
framework. The bank’s primary objective of maximizing shareholders’ wealth is depicted as
being shaped by owners’ preferences, management’s attitudes and decisions, and society;
also listed are six policy strategies to achieve that objective. Management’s attitudes and
decisions, the regulatory and economic environment, and the objective of maximizing
investors’ wealth (shareholders), in turn, influence these policies. The success of these
policy strategies depends on the riskiness of a bank’s balance sheet, that is, the nature of
assets and the concentration of loan portfolios (Sinkey, 1992). The primary objective of the
board is to increase the realizable value of the equity whether on liquidation or through
trading. The market value is conditioned by many factors namely, endogenous factors,
namely, management attitudes, strategies, long-term business prospects and quality of
assets and exogenous factors such as political, socio-economic environment and/or
external shocks, therefore is subject to volatility (Kantawala, 2004). According to Harker and
Zenios (1998), financial performance of an institution – observable but non-actionable – can
be affected by its perfor mance along the axis of service del ivery and financial
intermediation. They concluded that the drivers of performance can be classified into,

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