The Banking & Credit Response To Covid-19

The Covid-19 pandemic has affected the whole world and every country is fighting to minimise its impact on its people. Even as the scientists are dealing with the aspect of health, the economic planners are grappling with the economic dimension. So, do we respond to it, in economic terms?

We begin by acknowledging that the crisis is unprecedented in the century and hence there are no easy economic solutions. There is a broad consensus that, in the short term, fiscal and monetary measures need to be as liberal as possible. We do not have the capacity of the developed economies. Yet, and therefore, we need to make our measures as efficient as they can be.

At any stage in an economy, there are three factors of production and the same are also claimants of the output. These are the owners of land, the labourers, and the capital providers. In the longer term, the market and non-market mechanisms help find an equilibrium model for the allocation between the three. But at times of deep stress, like now, the policy makers need to decide their preferred intended allocation of the fiscal and monetary relief measures to these three claimants.

In the short term, the low income and unemployed labourers need maximum support. The government needs to focus on how to maximise the support to this class. There are already claims, some veiled in neo-liberal theologies and some openly, for protecting the interests of the owners of capital and land as well. These would have been valid in normal circumstances, but, today, they need to be traded off for supporting the poor wage earners. The government and the Reserve Bank of India (RBI) should both be interested, in the immediate term, in alleviating any hardships to the poor.

In light of this, let us focus on the monetary measures announced by the RBI.

Measures by the RBI

The primary hypothesis of the RBI is that adequate liquidity along with some moral suasion will induce the banks to lend more to, and recover less from, the borrowers. RBI has reduced the repo rate, relaxed the provisioning and asset classification norms, and provided increased liquidity.

Unfortunately, the aforesaid measures by RBI will not make any bank, which has the interests of its shareholders in mind, increase its lending to the poor or under privileged sections.

The Borrowers’ Constraint

The AAA and AA rated corporate borrowers are borrowing, mostly to refinance their existing loans at lower rates. We have just witnessed one of the largest prime borrowers doing the same. These corporate borrowers are fully justified in doing the same to the extent that it enhances the return on equity (ROE) for their shareholders.

The lower rated corporate borrowers need money today for two purposes. Their first priority is to meet their payment obligations to employees, creditors, lenders, and others. The second need is to

get back into running their business at a normal level. They are not looking at expanding their businesses as of now. The relief measures, from RBI, like moratorium on repayment obligations and income recognition and asset classification (IRAC) norms do help them to some extent but do not move the needle much. Most of the micro, small, and medium enterprises (MSME) borrowers, in the current situation, had been anyway reconciled to defaulting on their bank loans. The de-facto situation has now been converted into a du-jure situation.

The Bankers’ Constraint

Now, from the perspective of a commercial bank looking at maximising its ROE, the relief measures are just accounting adjustments. A prudent credit risk manager cannot overlook the fact that the cash flows of a typical MSME borrower which should determine the latter’s credit risk, have dried up. So, she would be keen to see measures which actually revive, and enhance, the cash flows of the borrowers before being ready to lend any fresh money to them. The bank would, of course, also estimate the direction of credit rating of the borrower, once the crisis gets over, as it does even at normal times.

A relaxation of the IRAC norms makes only some of the investment analysts happy, though, strictly speaking, it should not. Without getting into details, it can be asserted that the real risk of a bank is not affected by accounting or regulatory norms, but by the behaviour of its customers. A relaxation of the IRAC and provisioning norms do serve to increase the available regulatory (not economic) capital of a bank. In normal, and even more in bullish, circumstances, this allows an average bank to lend more to its customers. A smart bank would not do that because its lending and risk management actions are linked to its economic capital, and not the regulatory capital. We have seen enough evidence of the outcomes of the mis-directed behaviour of a few banks in global as well as recent Indian contexts.

The Suggested Solution

The core of the current economic problem is that there is extreme risk aversion amongst business owners. Survival, and not growth, is on their minds. It needs to be appreciated that risk aversion of a business person can be reduced by offering higher volume, or lower cost, of funds only if she sees a benefit in taking more risk. But, when the assumption of upward sloping indifference curve is in question, like as of now, she would not see any benefit in taking more risk.

Risk is perceived to be high in the minds of the borrowers, today. The solution lies in offering real measures that appeal to their risk perception. These lie mostly in the domain of the governments, at various levels.

RBI should, therefore, not bother about liquidity beyond what has already been announced. There is enough liquidity already available.

It should incentivise the flow of credit through all channels to the lowest income people and MSMEs. The entire chain of flow including non-banking finance companies (NBFCs), small finance banks (SFBs), micro finance institutions (MFIs), business correspondents (BCs), and related parties should be provided support through a special purpose vehicle, let’s call it BHARAT-SPV. The BHARAT-SPV can be capitalised by the government for funded and non-funded support. The credit from the BHARAT-SPV should be supported by first loss absorption by the government, through equity capital as well as guarantees. The amount, limits, and eligible customers can be easily determined based on the amount of resources committed by the government and the extent of intended benefits.

The BHARAT-SPV has the following advantages:

a) Funds will be ring-fenced and reach the intended beneficiaries rather than a lion’s share going to large corporate borrowers from the banks, as of now.

b) Credit flow will not be constrained by the limitations of ROE incentives of banks. While it is assumed that public sector banks (PSBs) will be less constrained in this respect, we have now learnt our lesson well in this regard. In fact, the current exhortation by the RBI to the banks for increased lending is quite likely to be followed up by the PSBs. But it will eventually lead to poor outcomes. So, a directly funded credit from the government is better than using the PSBs for non-commercial lending.

c) The MFIs, NBFCs, and a section of the banks lending to the poor households need a specially carved out funding support, which can be done through the SPV.

d) The terms of operation of the SPV can be altered easily and swiftly by the government, if and when there is a need to do so.

A proper design of incentives and execution of the same is the fundamental basis of efficient economic frameworks. Let’s hope that it is done in real sense.