Will The Restructuring Of Loans Help Small Borrowers?

The Reserve Bank of India (RBI) announced a few developmental and regulatory measures as a part of its recent monetary policy statement. While the intent of the RBI is much appreciated, there are some fundamental lacunae in the formulation of some of these measures. Let us look at one of them.

Restructuring of micro, small, and medium enterprises (MSME) debt: “A restructuring framework for MSMEs that were in default but ‘standard’ as on January 1, 2020 is already in place. The scheme has provided relief to a large number of MSMEs. With COVID-19 continuing to disrupt normal functioning and cash flows, the stress in the MSME sector has got accentuated, warranting further support. Accordingly, it has been decided that stressed MSME borrowers will be made eligible for restructuring their debt under the existing framework, provided their accounts with the concerned lender were classified as standard as on March 1, 2020.” (quote from RBI statement of 6 th August, 2020, italics are of the author).

Even as the loans to MSME firms were earlier allowed to be restructured, the stress in those firms has increased. The stress is likely on account of disruptions in the business operations as well as the difficulty in financing for these firms. It is difficult for the RBI to address the former part of the problem. It has tried to address the latter part through forbearance allowed to the lenders for lending to MSMEs.

A lender considers two factors while assessing the cost of lending to a MSME firm, or for that matter any firm. One is the direct cost of the funds. The other is the credit cost, i.e., the potential loss to the lender in case of likely default by the borrower. For arriving at the credit cost, a lender evaluates two factors.

a) The credit cost derived from the probability of default on the loan, based on the lender’s own credit risk assessment exercise. Let us call the estimate of this cost as A.

b) The regulatory provisions to be made by the lender in case of a loan turning sub-standard. Let us call this cost as B.

Both A and B are supposed to represent the credit cost of a loan. So, which one does a lender choose?

Before answering this, we must note the difference between A and B. The cost, A, is real and exogenous. It is independent of what a lender or a regulator wants it to be. But the cost, B, is just what is prescribed by the RBI. It may be the same as, or quite different from, B. In any case, since B is prescribed by the RBI, this is the minimum level that the lender must accept and incorporate in the lending decision.

When A and B are similar, the lender can pick either of the costs as its credit cost. But what happens if A and B are significantly different? In such a situation, the answer depends on what the motivation and current situation of the lender is. A lender following strong risk management practices will always price the loan based on its internal risk assessment of the credit cost, i.e., A. But a lender who is keen to show short term profits, even if at the cost of long term financial health, will prefer B, if it is less than A.

Let us see how this would play out when a lender is assessing a MSME borrower which has a weak credit profile, as in the current Covid situation.

The following table presents the mix of the factors and the outcome, from a lender’s point of view. It is assumed that the lender is aware of both the costs, A (= risk based credit cost) and B (= regulatory provisioning based credit cost).

The table above shows that even if the RBI relaxes the regulatory norms for provisioning, the benefit in terms of increased lending to the MSME borrowers will be limited. There are only two sections of lenders (No. 3 and 7 in table above) who may lend in the current situation. Even that will lead to a situation of moral hazard, wherein the lenders will eventually witness a rise in their non-performing assets (NPAs). The RBI will be then be dealing with another systemic problem. This is clearly not an optimal solution to the crisis faced by the MSME borrowers.

The afore-mentioned picture is not a revelation that the policy makers would not be aware of. But they are being forced to choose this sub-optimal path in the absence of longer-term real measures that should have been taken over the years.

So, what should the policymakers do? That is the subject of another piece of discussion.