India’s reserve bank recently introduced new measures under its long existing priority sector lending policy that mandate banks to lend a minimum percentage of their net credit to small businesses. But is forcing banks to lend to small firms such a good thing?
Under the new rules, announced in April, banks must by March next year ensure that they lend a minimum of seven percent of their net credit to small businesses and a minimum of 7.5% by March 2017.
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For banks it means more work. They will have to continue to ensure that a total of 40% of their net credit goes to priority sectors (sectors like small farmers, export, renewable energy and small loans for education and housing), while also meeting the new sub-targets for small businesses and other sectors.
For foreign banks the sub-targets for small and marginal farmers and micro enterprises would apply from 2018 following a review in 2017, the reserve bank said. Previously foreign banks weren’t required to meet a specific target to lend to small businesses, just the overall one to lend 32% of credit to priority sectors.
But while the screws are tightening for banks, they have been offered a new solution which could help them to meet targets. This, as for the first time banks be able to meet their targets by buying debt linked to priority lending (using a certificate) from those fellow banks which have already surpassed their targets.
Micro lending institutions — which are closer to the target market — will not be able to sell certificates to banks. But they will benefit indirectly — with the launch of the Micro Units Development Refinance Agency (Mudra) Bank, also in April.
This is because Mudra’s lending capital is being sourced from the shortfall owed by banks in priority sector lending (usually banks that fail to meet the target are mandated to place the shortfall in lending in the Rural Infrastructure Development Fund). When it operational it will lend directly to micro enterprises and to micro-financiers who would then onlend to micro enterprises.
MV Nair, the head of a committee on priority sector lending said in April that the certificates will allow banks to more easily meet the targets as those banks that have the infrastructure to lend to priority sectors can then surpass targets, and pass their liabilities on by selling these certificates.
Bank credit to MSMEs
While total bank credit to the small business sector stood at 7.9 trillion rupees in 2014, the new changes are aiming at addressing the supposed shortfall in finance to small businesses, which is estimated to be 32.5 trillion rupees, according to the International Finance Corporation (IFC). In addition Nair’s committee estimates that only five percent of small businesses have access to finance.
Like this the state argues that it must continue to intervene and force banks to lend to small businesses. With the stricter measures in April the reserve bank hopes to ensure that this gap is closed.
Impact so far
So how has the policy fared so far?
India introduced its priority lending policy in 1969 following its nationalisation of banks. However lending targets only came into existence in 1974. The target for public banks has remained 40% since 1979, while foreign banks have had to meet the 32% target since 1993.
A study released in January by Shilpa Rani and Diksha Garg of Kurukshetra University, concluded that both public sector and private sector banks have struggled to meet their respective targets over the years.
Another, a 2013 study by Najmi Shabbir, revealed that in 1969 the share of small-scale industries lending in net bank credit by private banks came to 10%, peaking in 1989 at 20%, before almost consistently sliding – to six percent in 2011. Public sector banks fared little better — beginning at 8.3% in 1969 and peaking at 17% in 1989, before consistently sliding to 11% in 2008.
Since the category of MSME was created under the MSME Act in 2006, the percentage of credit to the sector by public-sector banks has climbed from 11% in 2008 to 15% in 2011, while for commercial banks it moved from almost 12% to 10% over the same period.
While some like Manavjeet Singh, the managing director of Bestdealfinance.com say banks must understand the small business sector better and design relevant products to meet lending target, others point out that the rule stack more demands on Indian banks that are already accumulating more bad debt.
Between 2001 to 2013 loans to small businesses made up just 8.9% of total bank credit, but represented 15.1% of non-performing loans, according to figures by CARE ratings. Last year the gap closed a little — for public banks these were 5.2% as against 4.5% for non-priority sector loans in 2014.
This may not be surprising — a 2008 World Bank study indicated that the average non-performing loan ratio in developing countries for SMEs is 6.5%, compared to 4.1% for large firm loans
But there are other concerns. Priority sector lending requirements may also discourage foreign banks from entering a market to the extent they must follow the same mandate. This locks out competition.
It’s also costly. A 2013 study by consultants Nathan India found that the difference between the returns and costs on small loan sizes (10 000 rupees) for public sector banks is (-) 27.6%, for private sector banks it is (-) 12.7%, and (-) 11.7% for foreign banks.
The consultants found that countries (Japan, Korea, China, Brazil, and Thailand) that have used directed credit programmes shows that the overall costs of implementing such programmes are enormous relative to the benefits that they generate, thus reducing the net benefits to the economy.
Consequently the consultancy notes that several countries have phased out their such preferential or priority lending policies, or are in the process of downsizing them despite the fact that these programmes are extremely difficult to discontinue once introduced.
In the end lending to small businesses in India by banks is being heavily subsidised by the state, which still owns the majority of the country’s banks.
India’s 26 public banks accounted for 84% of branches and 76% of advances in 2012. India also has 20 private sector and 40 foreign banks.
Had it not been for the heavy state involvement such a policy would have been near impossible.
But more than the risk of growing debts which could place the banking system at risk, the policy could drive banks to lend badly – to businesses that don’t deserve to be funded, creating a lot of inefficiencies all propped up by cheap credit.
Under the code, which runs from 2012 to 2017, banks must lend out R48-billion (US$4-billion) in targeted investments, which not only includes financing black-owned SMEs, but also financing black farmers, affordable housing and transformational infrastructure.
The first Financial Sector Charter — which ran from 2004 to 2008 — specified a target of R5 billion that banks were expected to advance to black SMEs during that period. During that time banks surpassed the target by lending out R11.4-billion.
Unlike in India there are no direct penalties for banks that miss these targets (except that banks with a better score are more easily able to punt for work with the government).
In addition the targets run over a five-year period, which gives banks some time. They also don’t specify directly on the amount that must be lent to black-owned SMEs — allowing banks that are stronger in some of the other areas to still meet the target.
But like this banks could also underplay lending to black-owned SMEs, opting instead to focus on the other sectors which make up the target.
Yet by all accounts banks are getting stuck in. Nedbank’s 2014 Transformation Report reveals that the bank’s new loans and disbursements to black-owned small businesses totalled R1.7-billion, up from the R1.1-billion it lent to 2,989 black-owned small firms in 2012. Lending by Standard Bank to black SMEs has more than doubled — from R1.8-billion in 2012, to R3.7-billion last year.
Still a drop in ocean
Yet this these figures show that lending to black-owned SMEs still makes up just a minute proportion of banks lending to small businesses — which as of September 2013 stood at R179.5-billion for SME retail lending (retail loans of less than R7.5 million lent to small firms), according to reserve bank data.
While the South African example perhaps shows how far things still need to go — and black entrepreneurs must also be helped to develop more bankable ideas — it also offers another way in which the state can slowly begin go tighten the screws on what one institution often loathed by small business — banks.