The announcement of Public-Sector Bank (PSB) recapitalization by the Centre is a welcome step. A strong Public-Sector Banking sector is a top priority for India.
The announcement of Public-Sector Bank (PSB) recapitalization by the Centre is a welcome step. A strong Public-Sector Banking sector is a top priority for India. That said it is important to pay heed to the mistakes of the past regarding poor lending standards and improve upon them. The increased attention on Micro, Small and Medium Enterprises (MSMEs) in the recapitalization is commendable, but one must realize that correct mechanisms, infrastructure and risk mitigating techniques must be utilized to ensure that lending to MSMEs bears the right results. Better credit availability for MSMEs is essential to promote growth and job creation, but one must strive to innovate around Public-Sector Bank lending to ensure an efficient banking system. It is important that the government should start looking at ways to scale up the wholesale lending market. While it is important for MSMEs to have access to credit, it is equally important that lending standards do not drop. One possible path to promote MSME lending is for Public-Sector Banks to focus on lending to specialized Non-Banking Financial Companies (NBFCs) even more.
We feel specialized NBFCs with improved compliance standards are better placed to manage credit risk. The Public-Sector Banks should instead focus on managing the risk of the NBFCs that they make the wholesale loans to. Managing the risk of the NBFCs would involve stringent risk management techniques around balance sheet quality, corporate governance and due diligence conducted by the NBFCs. The Public-Sector Banks should ensure that wholesale banking compliance is improved further to weed out NBFCs that are not creating value or not maintaining requisite lending standards. The Public-Sector Banks should also look to be innovative around the financial structures that are used to lend to the NBFCs. Public-Sector Banks need to find the right balance between allowing the optimal flow of credit in the economy and avoiding moral hazard associated with lending. Innovative yet simple financial techniques and their variants must be looked at.
For instance, the Public-Sector Bank that makes the wholesale loan to the NBFC can collateralize a portion of the NBFC loan portfolio against the wholesale loan. The collateral acts as protection for the Public-Sector Bank to incentivize the NBFC to ensure better lending standards. While collateralized lending is nothing new, the Public-Sector Bank’s ability to devote its time and resources towards assessing and monitoring the loan portfolio will help improve lending standards to the NBFCs. The Public-Sector Banks and the regulators will also have to work to ensure that the collateralization process is seamless. The NBFCs in turn can use their resources to improve credit flow in the economy by providing credit to the MSMEs. Alternatively, the loan portfolio that the NBFC creates can be put in a Special Purpose.
Vehicle (SPV) and only after the interest coupon due to the Public-Sector Bank is paid out will the NBFC receive any payment on the loan. A variant of such a structure incentivizes the NBFC to maintain high lending standards. The ability of the Public-Sector Bank to focus on the NBFC risk and the NBFC to focus on the MSME risk also has the potential to better demarcate good risk from bad risk. The ability to do so will help fund good projects and create a more efficient credit system. In summary, MSME lending is of prime importance in India. While the Public-Sector Banks are the driving force to promote lending and growth it is important to look at alternative wholesale banking solutions that exist. Innovation around existing solutions can lead to better results. For us compliance of wholesale banking will be key to ensuring that the mechanism suggested above can deliver the required results. It is important to note that we suggest a gradual shift towards using specialized lenders to boost credit flow. Regulations and policy implementation must all also move hand in hand to ensure that the shift towards better lending standards can happen in India.
By Taponeel Mukherjee
(The views expressed in this article are personal and that of the author. The author heads Development Tracks, an infrastructure advisory firm. He can be contacted at firstname.lastname@example.org or @Taponeel on Twitter)