SME lending – it is time to create a new Paradigm

In my new avatar, I work a lot with small and medium businesses trying to secure bank / NBFC financing. The first question that lenders often ask, even before seeing the proposal, is “what is the collateral?” And of course, collateral means land and building. “We require at least 1.5x collateral to cover both funded and non-funded facilities”. Not surprising as for the last few years we have got used to lending (call it structured, collateralised or plain-vanilla) only against “hard collateral” even if it is for lending working capital.

Tired after one too many of these conversations, I finally asked the young analyst (on whose hapless shoulders the proposal had been thrust – which leads me to question the time-honoured judgement to have junior Relationship Managers screen new proposals) on how many businesses requiring INR 20-50 crs of debt would have that level of “hard collateral” to offer? On the defensive, he argued that should be the norm for “such a business”. What type of business, I countered? Working capital intensive. Absolutely, I enthusiastically added and the quality of receivables is top notch; can we structure a carve-out so that the collateral requirements are lower? Yes….no,,,,but…. Realising the futility of the conversation, I put the young gent out of his discomfort. After all, he had not set the underwriting standards for the bank.

Evolution from Cash Flow based lending to Collateral driven LAP

           When I began my career in a blue-chip corporate bank, we were taught cash was king and that security was just that ie collateral that could take years to recover, if at all. Collateral could not be the main driver for a lending decision. We did not have advanced credit measuring models or access to extensive research. We were taught to understand the business, its business cycle, customers, suppliers, key dependencies etc. In those primitive times, we had to physically sign off on all “high-value” cheques so we knew exactly where the funds were going, we would get our hands dirty scrutinising LCs and monitor the transactions going through operating account. And most important, we had to be close to the client - a young RM’s worst nightmare was your boss getting to know something that you were not aware of!

           The lending paradigm has of course completely changed since and I have been part of that evolution that has seen banking frontiers expand aggressively into new customer segments with established PD and LGD models and account profitability being strictly measured against allocated risk weighted capital. In this scenario external credit ratings and availability of collateral have emerged as primary drivers of credit.

Do CRAs need to re-look at their models?

We don’t need to think too much back in the past to know that credit rating agencies (CRAs) have failed to warn investors / lenders of potential default in AA / AAA rated paper. CRAs have their set of challenges, of which most cited are “issuer pays” model and rating shopping. These are real issues though lenders do discriminate amongst rating agencies based on perceived “quality” and “credibility” of CRAs and often insist on a rating from the top 3 / 4 CRAs. In the most recent case however it was neither of the two issues that played a role. It was about confirming shareholder support to inject funds to meet immediate liquidity commitments – which arguably was the most critical box that needed to be ticked. While lending to weaker group companies or subsidiaries, lenders rely on written corporate guarantees or comfort letters duly authorised by Board Resolutions. In the rare case where only verbal support is available, such support is taken from the Chairman of the Group and is valid after the bank records it in the form of a written communication reiterating such commitment. In IL&FS ownership was diffused amongst different institutional shareholders; I haven’t yet seen any articulation of how the rating agencies were assured by the multiple shareholders (or at least the largest ones) to confirm that they would support imminent liquidity commitments.

Given the above backdrop and the NPA scenario that the lending industry has seen, it is time to revisit credit lending paradigms, especially those related to the smaller businesses.

Are lenders missing the opportunity to finance the (Missing) Middle?

Table 1: Sectoral distribution of credit: April 2018 –Jan 2019

Source: Reseve Bank of India; CARE Ratings

MSMEs contribute 28.8% to India’s GDP; contribution of Manufacturing MSMEs in the country’s total Manufacturing GVO (Gross Value of Output) at current prices has remained consistent at c.33%, during the last five years. [Source: Central Statistics Office (CSO), Ministry of Statistics & Programme Implementation; Annual Report 2017-18 published by Ministry of Micro, Small and Medium Enterprises]

Yet as the above table reveals, over the last few years, lenders have increased their exposure to retail and services sectors thereby reducing the share of industry in the overall outstanding credit as seen by the tepid growth percentage this year. Within the industry segment large industries account for more than 80% of outstanding credit followed by micro and small industries at 13%. Medium industries account for only 4%!

A few years ago, SME / MSMEs emerged as a viable and attractive lending opportunity. Lenders started with tapping the supply chain of large corporates and gradually this evolved into a stand-alone customer segment with higher margins and adequate collateral. The challenge often starts when lenders have to scale up their risk appetite to keep pace with the growth of the borrowers business without there being adequate collateral cover for incremental facilities and subdued credit ratings.

Credit rating models will always factor in the size of a business, turnover, profitability margins, industry size and the company’s own positioning within the industry. Many small businesses will not score high in the above parameters because of the very nature of business. Emerging corporates will have modest but acceptable financials, face competitive pressures and may not have the latest product technology. Also as a measure of being conservative, lenders will tend to assign lower scores in the subjective part of the credit rating model.

A promoter that I am working with rued that nobody cares that his business employs 150 people and that there has not been a single day’s delay in paying their salaries. Data points like these, the fact that these promoters have created scalable and profitable business propositions, built markets and customers or that they have emerged stronger after weathering business storms and along the way have learned important lessons (like customer diversification, importance of financial discipline and the pitfalls of SMA reporting) are not captured. If the business incurs a loss, it gets immediately penalised with lower credit ratings and reduced working capital limits, even though leverage continues to be modest and arguably at the time when the business needs more financing support to re-build its customer base. Equally, there is no immediate reinstatement or increase in working capital limits when the business bounces back the next year even if the growth can be evidenced.

Is Collateral the only reason to lend?

When the promoter pledges all or a substantial portion his personal collateral, it also signals his intention to repay, which is a sign of comfort for the lenders. Beyond that, to seek more collateral (and that too acceptable collateral – one of the lenders told me that the location of the promoter’s flat was not attractive!) is often adding insult to injury. Businesses need working capital, often in the form of non-funded facilities ie Letters of Credit and Performance Guarantees, where the incidence of risk is lower. Bankers could consider a carve-out for such facilities.

One of the lenders told me that they only do structured trades and not plain vanilla lending. I was intrigued and wanted to understand more on the types of structures - when I realised that the structure was primarily predicated on pledge of shares. Again we do not need to look back too far in the past that such pledge of listed shares (more liquid than land and building) is not a guarantee of recoverability.

Banks like to be acknowledged as Preferred Banking Partners, are they?

After interacting with many businesses, I have now reluctantly accepted when most promoters say that the banking system has generally not been supportive to this segment. I have seen delays in renewing credit facilities and releasing working capital limits pushing businesses to lower credit ratings and even stress, lack of responsiveness to the extent of causing financial loss to the customer, unreasonable charges being recovered et al. Bankers like to call themselves as partners and hence this lack of responsiveness, especially in a sole banking situation is mystifying.

Is it time to revisit the credit paradigm?

So is it time then to re-establish the primacy of cash flows as the main driver of lending decisions? The challenge that most lenders will cite will be the quality of financial numbers made available. In the last few months, transparency has increased, thanks to implementation of reforms like GST. Going beyond the financial numbers and mapping the business’s ecosystem and speaking to suppliers, customers and auditors, scrutinising the operational accounts, assessing regularity of payments to vendors and collections from debtors, verification of order book and identifying key dependencies (which could be the right technology platform in a particular business or regularity of replacement capex in another) could give a better understanding of the business. If lenders can clearly define the specs, a large part of this work could be outsourced to independent agencies. The additional investment that lenders make in this process would be more than compensated in terms of the increased lending opportunity to the universe of present day small and medium businesses.