Managing defaults in small loans and agricultural accounts
Shri R Bhaskaran
CEO, IIBF.
Background
Working capital finance, based on cash flows, is available for small industry in the organized sector. The smaller units, that would be classified under employment oriented lending, PMRY, small business finance and the farmers are financed based on a "best fit to the template financial model" of the commercial or cooperative banks. Perhaps this cannot be avoided, as individual credit-risk analysis of each credit application would require the commitment of large resources in the form of field staff. Committing such resources would cause a dilemma in loan pricing based on incurred costs vis-a-vis MLR for such loans.
Cash flows for small loan borrowers come from a single stream and not multiple sources. (It is only large corporations and multinationals that can have incomes from diverse activities; a small unit is usually a single product or single market entity.) Any disturbance in the stream of cash flows would lead to inadequacies and resultant defaults. As a number of factors could cause such cash flow inadequacies, default in small loan accounts and farm loan accounts could occur due to a number of reasons. Often, political2 interference and poor financial indiscipline of the borrower are cited as important reasons for default. In an economy where income distributions have been uneven, political bosses do see a need for softer application of loan recovery processes. Culturally, therefore, there is a built in expectation of political intercession in times of difficulty and this acts as a disincentive for better financial discipline. While this could be a major cause, one cannot overlook the impact of other causes such as economic downturns, supply chain disruptions affecting production, natural calamities, fluctuations in price of produces, seasonal cash flow inadequacies etc on business and loan performance. Borrowers' capacity to manage cash flow inadequacy related risks and availability of risk management tools would critically impact the performance of small loan and rural portfolios of banks.
Genesis of Default
Default in a loan account occurs when interest or installment payable is delayed and the repayment of principal is delayed or denied. In the event of default continuing beyond a specified period the accounts are to be treated as NPA and the IRAC norms apply3. Income/Income levels of small borrowers and agricultural accounts may be affected by factors such as business cycle (monsoon being a major determinant of business cycle), collection inefficiencies, production losses and poor productivity. Power failures resulting in delay or lag in production and breakdowns causing additional expenses are not uncommon. Tractors and machines fail. Wells dug at huge costs produce no water. Pest attacks reduce plantations to nothing. Severe summer reduces the milk output of cows and dairy income comes down. All these factors affect income; result in losses and cause default.
Default being a function of losses and other cash flow inefficiencies, should be managed by (a) suitable loss insurance and (b) suitable repositioning of the loan repayment or installments. These are not mutually exclusive options. In fact these should be available together. Mere availability of loans without insurance will only tend to make small loans unviable. In this context it may be relevant to examine the reasons for the rather indifferent success of the Deposit Insurance and Credit Guarantee Corporation with regard to credit guarantee.
Default becomes willful if it occurs despite good production, business volumes and where situation is otherwise normal. This would show that funds have been diverted or misapplied. When loan funds have been used for other than those for which the loan has been agreed upon and if default occurs, the default is willful. Willful default calls for a different treatment. These defaults have to be pursued for full recovery. Collateral efficiency plays a crucial role in such cases.
There are certain systemic causes of default. Stipulation of repayment obligation far in excess of likely cash flow, stipulating a high rate of interest, linking deposit mobilization efforts to loans, high collateral cost, need to borrow from informal sources for meeting margin requirement etc. These aspects tend to increase defaults. These issues revolve around poor appraisal skills and mindless adoption of standard norms across a set of borrowers.
One Time Settlements
What ever the reason for default banks manage or try to reduce it by offering, to the borrowers, extension in repayment period or postponement of installments. Often interest concessions and/or waivers accompany these measures. One of the popular ways in which the banks have been extending such concessions in handling default in the case of small loans is through a series of "One Time Settlements". (OTS)
In the case of industrial advances, which had become NPA s, OTS was extended in the form of Corporate Debt Restructuring (CDR). Industrialists and big borrowers, thanks to the softening of interest rates in the market, were able to meet their commitments under CDR by accessing market funds at competitive rates! Thus financial reforms benefited the industries. They were able to take advantage of the opening of the market in reducing their exposure to banks. In addition they were also able to benefit from the softening rates. In view of the buoyant industrial scene now, one can conclude that CDR has positively impacted the economy.
OTS for small loans was not successful in bringing down, by any significant levels, the number of default accounts. It is pertinent to add here that authorities had come out with a series of "One Time Settlements". Yet it, perhaps did not achieve the objective of helping the small borrowers, as there was no effort at linking OTS to cash flow inadequacies of individual borrowers. OTS presumed that small borrowers had cash availability to take advantage of OTS and interest concession. OTS was a " one size fit all" measure and did not take into account the fact that borrowers might not have adequate cash flow let alone access to funds to take meaningful advantage of OTS. Moreover, unlike CDR, OTS beneficiaries were, under initial guidelines, barred from further loans4 . Thus, despite the built in facility of paying the "settlement sum" in installments, most of the small loan borrowers could not avail of the OTS. Possibly some of those small account holders who opted for OTS hoping to be rid of the debt, could have found that commitments were difficult to meet, and accessed informal money lenders who continue to flourish despite nearly three and half decades of Development Banking. A reason for the success of CDR was that to meet the settlement commitment, corporates had access to market or funds from other banks whereas no such access was available for the small loan accounts. It is also a pertinent that the ROI in small loans did not fall in line with softening market rates. Thus some of the intended benefits of financial sector reform did not reach the small loan and rural borrowers.
High Levels of NPA
This can be verified by the fact that, as of March 20045 commercial banks and Financial Institutions -whose exposure to corporates has been much higher than to small loans-had an over NPA level of 7.79%, and FI's are in turnaround mode, whereas banks, such as District Central Coop banks (22%), RRBs (12.63%)6 , Land Development Banks (PCARDBs-33%) and Urban Coop banks (17.6%), whose business mix is almost entirely made up of small loans continue to have very high NPAs. The average NPA of this segment is estimated to be around 22% in 2004. It is also pertinent to note that in their advances to priority and weaker section the commercial banks showed an NPA of 18.90 %. This would indicate that nearly a fifth of their combined exposure is in default!
The above levels of NPA has remained despite a number of measures, beginning ARDR 90, subsequent waivers announced time to time by many state governments, two " one time settlements", and special OTS schemes announced for loans upto Rs 25000 / Rs 50,000 loans. It is evident that small loans and agriculture loans need much more than reschedulements and waivers. In fact they need risk mitigants and that too in good measure.
Inadequacies of Insurance Schemes
It was previously seen that availability of insurance is important in managing the risks of small business. A perusal of available insurance plans for indemnifying small loan assets, farm assets and crops would show that these are limited in scope and do not adequately cover issue of cash flow inadequacies and reduction in income which vitally affect the viability of the venture/loan. In fact the definition of loss7 in insurance parlance does not cover many of the issues that cause cash flow deficiency in small loans. Moreover these insurance products/policies were driven by the needs of the banks and were developed with bank loan in focus. As such little thought was given about the efficacy of these policies in affording protection to the small loan borrower against losses. In effect, though the borrower paid the premium, insurance was designed to protect the lender. It is for this reason that wherever the small business or rural activity was self financed (i.e. outside 'bank finance') these insurance policies did not sell. Thus, neither the Insurance companies nor the insured are satisfied with the product. Insurance companies found the claim ratio tilted against them whereas the insured complained about the procedures and inadequacy of cover. Crop insurance is an example. Here issues such as size of the farm (small to big) level of stabilization (new to well established) source of irrigation (well or monsoon) etc which will influence the level of impact that rainfall deficiency or a natural calamity will have on production or productivity, were not factored in the pricing or settlement processes. Another issue is that banking/insurance sector recognizes monsoon failure or excess only when such shortfall or excesses is beyond a certain threshold level and only when losses are on an area basis. Thus smaller losses - which could still seriously affect the viability of agriculture or loan- are not recognized 8. If such losses were to occur a number of times- as it often does due to lesser precipitation in critical time for plant growth, over all rainfall remaining normal- the debt service becomes impossible. In comparison, SMEs, generally get a loss of property/asset cover for fire, riot or other risks and not easily for "loss of profits". And where loss of profits policies are available, these tend to be loaded against the small borrowers' interests.
Need for innovations in managing default/risks
From the above it can be seen that re-stipulating installments, rephasing/ capitalising overdues and giving additional loans may not be sufficient to avoid defaults. It is very clear that, except where losses are very small, additional loans will add up to the debt burden and can make debt service difficult. To help avoid default and to ensure that bank loans become productive a number of things are needed. A few suggestions are
