Credit guarantee helps banks take a chance on MSMEs but funding defaulters harms taxpayers

Since MSMEs are important for growth and employment, we need to understand the causes of the credit gap before increasing our reliance on policy interventions.

15 February, 2023
The Print

Micro, small and medium enterprises are perpetually starved of credit. A recent report suggests that the gap between demand of MSMEs for loans and what the financial sector is willing to supply is around Rs 25 trillion. Since MSMEs are considered to be important for growth and employment, we need to understand the causes of this gap before increasing our reliance on policy interventions that channelise credit toward this sector.

The Indian government’s response to the credit gap has been two-fold. The first is policy-directed credit where banks are required to lend 40 per cent of their net credit to what is termed as “priority sectors” including MSMEs. The second is a credit guarantee programme where the government guarantees bank loans to MSMEs. These have been around for a long time—from credit guarantee schemes administered by CGTMSE to the Emergency Credit Line Guarantee Scheme (ECLGS) run by the National Credit Guarantee Trustee Company (NCGTC) Ltd during Covid-19. The Budget 2023 announced an infusion of Rs 9,000 crore toward credit guarantees. This has enabled additional collateral-free guaranteed credit of Rs 2 lakh crore to MSMEs. The government also said that the cost of credit will be reduced by 1 per cent. A pertinent question to ask here is if these interventions solve the problem that afflicts the credit market for MSMEs.

Root cause of credit gaps

If there is an adequate supply of capital, why are some able to get more of it than others? Lenders typically need information on two parameters before extending credit.

First, the likelihood of getting the total money back. This requires understanding the creditworthiness of the borrower and the business toward which the credit will be deployed. Second, if the borrower defaults, then how much will the lender get back, if anything.

In modern economies, good information systems including credit scores help evaluate the former. A robust mechanism for collection, sometimes in the form of bankruptcy law, helps toward the latter. Both these systems help the lender decide which projects to finance.

In India, these frameworks are still evolving. This has meant large corporate houses, or those with “relationships”, were able to access credit. The difficulties in recovery meant that creditors required the borrower to post collateral. Unsecured credit never really took off.

Some of these bottlenecks have been reduced through the setting up of credit information companies and collection laws such as the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act 2002 and the Insolvency and Bankruptcy Code (IBC) 2016. But MSMEs are often more vulnerable on both these fronts—they may not have a credit history, and the bankruptcy law does not apply to them.

Cost of interventions

Directed credit does not solve the problem of information asymmetry or bankruptcy. It only forces banks to channel credit to certain sectors. While the benefits of such credit appear large at least to beneficiary firms, the costs remain hidden.

Credit guarantees, too, do not solve the problem of information asymmetry. However, from the banks’ perspective, they solve the problem of collection—if an MSME defaults on a loan, the bank doesn’t lose money as the government pays it the guaranteed amount. Banks can, therefore, take a chance on an MSME, which they may have been reluctant to do earlier. In effect, the government’s guarantee replaces the need for collateral. Credit guarantees protect depositors’ money since the nonperforming assets (NPAs) generated on account of MSMEs are already paid for. This creates a moral hazard. Banks could potentially reduce due diligence on loans. Also, since the guarantee is funded by the government, the taxpayer bears the cost. Society also bears a cost when credit gets allocated to unproductive firms.

Our experience with the Emergency Credit Line Guarantee Scheme (ECLGS) suggests that the concerns described above may well be playing out in reality. One in six loans under ECGLS had turned NPA. The share of micro enterprises in the NPAs was at 93.5 per cent in comparison to 3.2 per cent share of other business enterprises, 2.8 per cent of small enterprises, and 0.5 per cent of medium units. It is possible that these numbers reflect the distress caused during Covid-19. It is equally possible that some of the recipients of the guarantee schemes did not have robust business models. Their inability to source funds without government intervention reflected that the credit market was actually working.

Way forward

The design of the policy interventions becomes important. While progress has been made on developing and sourcing better information on borrowers, we need to think about ways to improve it further. One mechanism to incentivise banks to continue doing due diligence is to introduce a price for the credit guarantee. For every guaranteed loan, the bank pays a premium to the government. If the NPA rate rises, then the premium charged to the bank should also increase. Better systems are required to track the performance of these guarantees, and the impact that changing fee structures may have on banks’ performance.

Directed credit and credit guarantee schemes, therefore, should not become the only tools for closing the credit gap. It is more important to focus on solving the underlying problems of information asymmetry and bankruptcy.

How Sitharaman can live up to her Budget promise of KYC simplification

Our response to KYC problems has been to bring technology to streamline processes. The problem is that they often don’t work as well as one would have hoped.

01 February, 2023
The Print

Our lived experience suggests that KYC or Know-Your-Customer is burdensome. Address proofs are hard to come by, especially if one migrates to a new city. One KYC does not seem to ever be enough — each new transaction requires a fresh KYC process. Economic growth comes as much from innovation as from reducing frictions in the process-of-doing-business. By announcing the intention to simplify the KYC processes in her Budget Speech, Finance Minister Nirmala Sitharaman has recognised this reality. As the finance ministry begins to implement a risk-based framework, it will be useful to remind ourselves of the origins of KYC. Key areas such as address proof requirements and enforcement processes should become the focus of our reform effort.

The origins of KYC

There was, and continues to be, a general consensus that activities such as money laundering (ML), terrorism finance (TF), and weapons proliferation (WP) could be kept under check if financial flows supporting these activities could be identified, and thwarted at the right time.

A multilateral global body, the Financial Action Task Force (FATF), was set up in 1989 to issue standards, including those on customer identification and verification, that member countries could adopt. Member countries have to translate these into laws and regulations for their jurisdiction. After the 9/11 attacks, money laundering, terrorism finance, and weapons proliferation achieved more prominence than before. In 2002, Indian regulators had also implemented customer identification requirements under the Prevention of Money Laundering Act (PMLA) 2002. India became a member of the FATF in 2010, and since then our requirements under the PMLA have continuously been updated to also comply with the FATF guidelines.

FATF recommendations, however, provide countries flexibility on designing their KYC. For example, the FATF task force suggests that countries adopt a risk-based approach to identify and assess risks. That is, countries should identify the risk of money laundering or terrorism finance across sectors (or thresholds for transactions), and place different obligations on entities based on the risks identified. In fact, the FATF allows member countries to completely exempt certain types of transactions or financial institutions if the risk of money laundering/terror financing/weapons proliferation is low.

While FATF allows for a risk-based approach, India chose to not follow it. There are three main problems with how we do KYC: a) over-emphasis on address proof, b) incomplete technological solutions, and c) poor design of enforcement actions. These may be important constituents for change as we move toward simplification of our KYC processes.

Reduce the burden of address proof

An address proof is a requirement for pretty much every transaction in India. While regulators have made efforts to expand the list of officially valid documents that can serve as address proof, the question to ask is, why do we need them in the first place? These are not coming from the FATF — other countries have adopted liberal definitions of address, especially for low-risk transactions, including just a post box (PO) box number (the US), date of birth (Australia), a contact address with no insistence on “permanent address” (Germany). Rationalising the requirement of address proof should be the first step for KYC simplification. This could be done by not requiring a permanent address, but just a correspondence address. This could also be done by mandating all financial regulators to rely on the KYC that has already been done when opening a bank account.

Improve the design of penalties

Non-compliance of KYC regulation carries penalties. But penalties should be proportionate – that is, how stringent they are should vary with the seriousness of the offence. This does not seem to be the case with the Indian framework at present. Penalties often range from high fines to criminal sanctions and the possibility of cancellation of business licenses. There is also no appellate mechanism against regulatory orders. The lack of an appeals mechanism for RBI-regulated entities violates due processes. It is no surprise then that financial institutions choose to play it safe. The risk-averse strategy in an environment of poor enforcement is to conduct due diligence even though it may not be required.

Simplification of KYC is related to improving state capacity in regulation. The Finance Minister has already recognised the importance of decriminalisation in her Budget Speech. The design of penalties should be proportionate, and reasoned orders should be publicly available. The government should also constitute an appeals process from RBI decisions. Many of these recommendations were made by the Financial Sector Legislative Reforms Commission (FSLRC). The time to implement them in the context of KYC regulations may be here.

Moving beyond technology solutions

Our response to KYC problems has been to bring technology to streamline some of these processes. The problem is that they often don’t work as well as one would have hoped. For example, video and eKYC have not been implemented across the board. They rely on technology that can often be exclusionary itself. They may create new privacy risks. They may also not be as cheap as is made out to be. More importantly, they don’t solve the root cause – a bad design of policy and enforcement processes. The use of DigiLocker and account aggregators may solve some of the frictions. The real solution, however, is in getting us to a place where tech solutionism is not required. Recognising the need for a ‘risk-based’ approach is a step in the right direction.

Yes Bank’s AT1 bonds tell the tale of broken financial regulation in India

RBI must explain rationale behind decisions related to Yes Bank resolution — mis-selling of bonds, delay in resolution & writing off debt over equity

01 February, 2023
The Print

The saga of the Additional Tier-1 (AT1) bonds continues. It started with Yes Bank selling these bonds to retail investors as high-interest yielding fixed-deposits, what followed was a chain of events in early 2020 — the bank getting into trouble because of bad loans, the RBI-appointed administrator writing them off, the bondholders suing in court, the Bombay High Court setting aside the write-off decision, and the case now likely to go to the Supreme Court.

This series of events illuminates the different ways in which financial regulation in India is broken.

The Yes Bank saga

In 2016 and 2017, Yes Bank issued AT1 bonds to increase its capital base. The bonds provide higher yields than other comparable bonds.

The catch? In case of a crisis, they can be converted to equity, or even be written off. That is, if you purchased these bonds, you would get a higher interest rate (than say a fixed deposit), but in the event that the bank got into trouble, there was a chance that you wouldn’t be paid interest, or your bonds would get converted to equity.

By March 2020 it was public knowledge that Yes Bank was in financial trouble owing to some of its loans becoming Non-Performing Assets (NPAs). The RBI appointed an administrator to deal with the bank’s solvency, superseding the Board.

The administrator put in place a scheme for its revival — State Bank of India along with some other financial institutions would purchase equity, while AT1 bondholders would get nothing.

Mis-selling of bonds

The first problem is the marketing pitch for the bonds. It is alleged that Yes Bank employees overemphasised the returns, and downplayed the risks of investing in these bonds.

Mis-selling by bank employees is not new. They have been known to recommend the highest fee-paying product, and rarely disclose costs and lock-ins. Consumer protection regulation by the RBI has yet to mount a comprehensive response to such practices.

In the case of Yes Bank, SEBI (Securities and Exchange Board of India) imposed a penalty on Rana Kapoor, the managing director of the bank for mis-selling. It further restricted retail investors from investing in these bonds.

In typical Indian style, we have not solved the systemic problem behind mis-selling, but just banned retail investors from investing altogether. This presumes that retail investors are dumb, and cannot make risk-return trade-offs once relevant disclosures are made. The decision means that banks are deprived of a source of funds and retail investors are deprived of a source of high interest-yielding instruments. There is little change in the distribution practices of frontline employees.

Resolution of Yes Bank

The second problem of regulation is the delay and the unpredictability around how the regulator deals with failing banks. In the case of Yes Bank, underreporting of bad loans was seen as early as FY16.

By 2019, credit rating agencies had downgraded the bank, and its market value had eroded. The moratorium, however, got placed only on 5 March 2020. Significant time was lost.

As has been discussed elsewhere, there is an inherent conflict of interest in the role of the RBI as a regulator of banks, and as a resolution authority. There has been no consistency in the manner in which bank failures have been resolved in the past. Sometimes they were sold to private equity funds, sometimes merged with other public sector banks, and sometimes bonds were wiped out.

This demonstrates the absence of a framework lack of regulatory clarity in the resolution of financial firms. The government’s withdrawal of the Financial Resolution and Deposit Insurance (FRDI) Bill in 2018 is another example of a lost opportunity to reform India’s financial sector.

The debt write-off

The third and perhaps the biggest problem revolves around writing off debt over equity.

The Basel III norms that guide banking regulators suggest that AT1-type bonds will be junior to all other debt, but senior to common equity capital of the bank. This is a reiteration of how finance works.

Equity holders get the upside if the firm does well but stand to lose their capital if it fails. Debt holders do not get the upside, but get paid before equity in the event of bankruptcy. This logic was turned on its head in the Yes Bank case.

Technically, the RBI may be able to refer to the master circular to justify the decision of the administrator. But the larger question is whether there was merit in challenging the provision that goes against the logic of how debt and equity work.

The ability of the administrator to write off debt before equity essentially meant that most institutional investors will be reluctant to invest in these bonds, leading to another important source of capital for banks drying up because basic principles of finance were disregarded.

The case is now in the Supreme Court. Regardless of the decision the apex court takes, fundamental questions around the design of financial regulation still remain unresolved. We need to revisit our frameworks on consumer protection, resolution of financial firms, and creditors rights.