NBFCs: superior to banks?

There is a common perception that NBFCs are structurally disadvantaged when compared to banks and therefore cannot perform on par with them. From raising capital at rates close to where banks lend, resulting in a higher cost of capital, to serving narrower customer segments where banks cater to a much broader base across products and geographies, banks often appear to have a clear edge.

At first glance, this conclusion seems reasonable. However, we hold a view that may differ from the prevailing narrative and in this blog, we aim to lay it out clearly. Let’s take a closer look.

First examine how the two business models differ.

Banks primarily raise capital through customer account balances and deposits. These funds are then lent out at higher rates. The difference between the interest earned on loans and the interest paid on deposits, the net interest spread forms the core of a bank’s earnings.

Most NBFCs, in contrast, do not have access to customer deposits. Instead, they raise capital by borrowing, largely from banks and capital markets. In effect, NBFCs borrow money at rates close to where banks lend, and then deploy this capital into their chosen lending segments.

So how do they stay competitive?

The answer lies in the way NBFCs structure and run their businesses. To understand this better, let us break down the NBFC business model and, in parallel, compare it with that of banks to see how NBFCs are able to compete with them.

Advantages that NBFCs model present:

• Focused customer and product segments leading to specialization

• Superior asset quality through specialization,

• Lean operating and distribution model

• Higher agility in technology adoption and execution leading to quicker loans

• Deeper reach into underbanked markets leading to superior pricing power

Focused customer segment and asset quality management

NBFCs typically focus on underserved customer segments such as micro to small loans for individuals and MSMEs. They offer a limited set of products that are specifically designed for the needs, cash flows, and risk profiles of these borrowers. This narrow focus allows NBFCs to build deep domain expertise and achieve a level of specialization that is difficult to replicate at scale.

For instance, Five Star Business Finance focuses on providing secured loans to micro entrepreneurs and self-employed individuals, largely across South India. This singular focus has allowed the company to build underwriting frameworks that go beyond traditional credit scores and formal income documentation. In practice, this becomes evident when a small entrepreneur from a rural area seeks a loan to start or expand a business. A traditional bank is likely to reject such an application despite the borrower’s ability to repay, often due to limited credit history or the absence of standard income proof. Five Star, on the other hand, is specifically designed to assess such borrowers. Through on-ground evaluations, asset-backed lending structures, localized risk assessment, and a deep understanding of borrower behaviour, it is able to evaluate repayment capacity in non-traditional ways and extend formal credit where banks typically cannot.

Banks, on the other hand, cater to a much broader customer base across a wide range of products. While this provides scale, it often comes at the cost of depth within individual segments. As resources are spread across multiple businesses, it becomes harder to achieve the same level of precision and consistency in areas such as micro and small-ticket lending. This limits banks’ ability to maintain the same level of underwriting quality in these specialized segments.

An intuitive way to understand this difference is through a retail analogy. Banks are comparable to large, all-in-one department stores like DMart. They offer a wide range of essential products at scale but are not designed to cater to highly customized needs. NBFCs, on the other hand, are more like Zudio. They focus on a specific customer segment, in this case value-conscious consumers seeking quality apparel at affordable prices and execute exceptionally well within that niche.

Given the nature of their target customer segments, NBFCs do carry higher credit costs than banks on an absolute basis. As shown in Figure 1 below, NBFCs have historically reported average credit costs that are around 0.56% higher than those of banks. However, this marginal increase in credit risk is more than offset by significantly higher lending yields, driven not just by risk-taking but by deeper penetration into underbanked customer segments that are underserved by traditional banks.

This results in higher interest income per unit of risk taken. In practice, this has translated into interest income that is approximately 4.5% higher than banks despite only a modest 0.56% increase in credit cost.

This ability to manage risk efficiently while generating superior risk-adjusted returns highlights the operational strength of well-run NBFCs.

Income statement comparison between banks and NBFCs 

Figure 1

Light business model

NBFCs inherently operate with a lighter business model compared to banks. Their expansions are primarily focused on improving lending quality and deepening penetration within their target customer segments, unlike banks, who have to expand to raise more capital in terms of deposits.

This allows NBFCs to operate with a more limited number of branches. This structural difference translates into lower operating expenses, particularly on branch and employee costs, as reflected in the table above. In contrast, banks incur significantly higher costs not just to maintain branch networks, but also to provide the full suite of services required to mobilise and service low-cost deposits, including transaction infrastructure, compliance, customer servicing, and regulatory overheads. In effect, these expenses represent an implicit additional cost of borrowing that banks carry and one that NBFCs largely avoid, narrowing the gap between the two. 

Taken together, the lighter operating model and focused customer approach have enabled NBFCs to scale efficiently in underpenetrated segments, while also supporting higher net profit margins relative to banks. As shown in the figure below, NBFCs have grown at a pace exceeding that of the broader banking sector and nominal GDP over the past five years. This growth reflects their ability to identify and serve specialized segments efficiently.

Key Growth rates: 2021 - 2025

Figure 2

Beyond growth metrics, NBFCs also play a meaningful role in economic development. By extending formal credit to underserved regions and customer segments, they help improve financial access and inclusion. This, in turn, supports entrepreneurship, reduces dependence on informal moneylenders who charge exorbitant rates, and contributes positively to the broader economy.

Risks of NBFCs

While well-run NBFCs are able to leverage operational flexibility and a relatively lighter regulatory framework to build strong, specialized business models, this same flexibility can amplify risks if not managed prudently. NBFCs that pursue growth without adequate underwriting discipline, balance sheet strength, or risk controls can find themselves in a significantly more vulnerable position.

• Credit risk - NBFCs typically serve customer segments with higher inherent credit risk. Weak underwriting or aggressive growth can therefore lead to elevated default rates and rising NPAs, particularly during economic downturns.

• Funding risk - As market-funded institutions, NBFCs are sensitive to interest rate movements and liquidity conditions. They rely on periodic refinancing of their liabilities, and if the borrowing and lending cycles are not well matched it can lead to margin pressure and balance sheet stress.

• Governance and execution risk - Given their relatively flexible operating models, NBFCs are more exposed to management quality and execution discipline. Weak governance, aggressive growth targets, or poor risk controls can quickly deteriorate the business.

Co-existence

While banks and NBFCs operate within the same financial ecosystem, they do not necessarily always compete with each other. NBFCs rely on banks for a portion of their funding, while banks rely on NBFCs to access underbanked customer segments and geographies efficiently. Through this partnership, banks are able to extend credit and earn incremental yield while offloading much of the operational complexity to specialized NBFCs, which leverage their on-ground presence, specialized processes, and local knowledge to deliver credit efficiently. Both the institutions focus on their specializations and play key roles as the financial pillars of the economy while relying on each other to cover their shortcomings.

While banks are important for financial development, NBFCs are important for financial inclusion.

References

• Press Information Bureau. (n.d.). Nominal GDP of India (2021–2025). Government of India.

• Top 5 PSU banks (2021-2025), Top 6 private sector banks (2021-2025), Top 10 NBFCs. (2021-2025) - internal calculations.

• Boston Consulting Group. (n.d.). Indian banking sector: Top updates. - internal calculations done on the raw data available. Disclaimer-This article is for educational and informational purposes only and should not be considered as investment advice or a recommendation to buy or sell any securities or adopt any investment strategy.