In April 2018, Business Insider India addressed the current state of the Indian credit market for Micro, Small & Medium Enterprises (MSME). The MSME credit market revolves around loans under ₹1 million or approximately 15,000 (2018) US dollars.
Recently, in November 2016, the demonetization plan in which the government of India declared that all the ₹500 and ₹1000 banknotes would become invalid and replaced with new banknotes in an effort to reduce counterfeit currencies circulating within the economy (India Today). In addition, in December 2017 the Reserve Bank of India (RBI) announced the Prompt Corrective Action (PCA) credit limit for Public Sector Banks (PSB). The PCA put 11 out of India’s total 21 PSB’s that had a 15% non-performing loan ratio on a watch list to establish and enforce a more conservative lending approach. The intention was to reinforce the balance sheets of these PSB’s due to their losses from defaults.
MSME’s are a large contributor to job creation and hence 40% of India’s GDP (Dhillon, D., 2018). Consequently, the PCA and demonetization plan distorted India’s GDP and MSME credit markets. According to the MSME Pulse Report, the PSB’s MSME credit market share was reduced and both Private Banks and Non-Banking Financial Companies (NBFC) gained a larger credit market share.
MSME Credit Market Share
Source: MSME Pulse Report
This increase in the MSME credit market shares for both private banks and NBFC’s resulted in higher interest rates for private banks and NBFC’s. This very link between a higher market share and the respective increase in interest rates due to the PCA framework can be explained through the neoclassical credit market theory and the influence of asymmetric information.
Neoclassical Credit Market Theory
The neoclassical credit market theory operates on two important principles: perfect information and competitive markets. Both lenders and borrowers have complete knowledge about the borrower’s investment opportunity and therefore the borrower’s repayment structure. The interest rate posed on the borrowers by lenders is equivalent to the opportunity cost of capital. If the project has positive returns, after accounting for the cost of loan, the borrower will choose to incur them. Given the nature of perfect information, the lenders would accept some uncertainty in production, but in this case the influence of asymmetric information is a more realistic assumption.
Banks in India face the problem of asymmetric information when deciding to approve a loan to an individual or MSME. Banks or creditors will gather information on prospective borrowers to determine their creditworthiness and reduce the bank’s credit risk. However, even with said due diligence it is difficult to determine exactly whether a borrower will default on the loan. For that reason, banks are forced to consider how the terms of each loan affect the entire pool of borrowers. As a result, the two problems that arise from asymmetric information are moral hazard and adverse selection.
Moral hazard can be divided into two types: ex-ante and ex-post moral hazard. Ex-ante moral hazard, in this case, is the risk that the borrower has mislead the bank regarding his or her collateral, financial standing and therefore creditworthiness. To combat the ex-ante moral hazard banks will adjust their interest rates according to the perceived risk of a borrower after screening the borrower. Riskier borrowers would receive higher interest rates to compensate for the creditors risk.
Ex-post moral hazard is the risk that the borrower does not use the money accordingly as agreed with the bank’s terms and chooses not to repay the bank. The ex-post moral hazard is more difficult to mitigate, but in theory banks would prefer to establish financial interlinkages or relationships with borrowers to ensure orderly conduct in future business. These interlinkages would incentivize a proper repayment structure for borrowers and establish a market segmentation in which the banks can continuously work with or loan to the same people.
Adverse selection is the risk of banks unknowingly loaning to riskier individuals or MSME’s which can result in higher probabilities of default. Banks will therefore raise interest rates to compensate for the riskier borrowers. Less risky borrowers will therefore be crowded out from the market, because they will not incur a higher interest rate, since safer borrowers have smaller profits compared to riskier borrowers. This very crowd out of safe borrowers is inefficient. It can also become a cyclical problem, because as more safe borrowers are crowded out the more pressure there is on banks to raise interest rates.
According to Joseph E. Stiglitz, the “screening” method can mitigate adverse selection. In that sense, banks would need to gather more information about the lenders to determine the creditworthiness of the borrower. However, as stated before, a borrower can mask his or her risk.
In order to understand the PCA framework it is important to understand how banks differ from one another. PSB’s operate differently than private banks and NBFC’s. Private banks and NBFC’s rely on their private shareholders and their customer base. For this reason, PSB’s receive funds from the RBI and are tightly regulated by them. In theory, private banks are more prone to a liquidity crisis. Consequently, private and NBFC’s offer higher interest rates than PSB’s, since PSB’s are tightly regulated and more conservative in their lending approach.
Nevertheless, as demonstrated by the Business Insider India Article, PCB’s have performed poorly and their non-performing loan ratios increased. For this reason, the RBI intended to reduce the risk of moral hazard and adverse selection by passing the PCA framework. This caused PCB’s to become more conservative when making loans. As a result, more borrowers turned to alternatives such as private banks and NBFC’s. To accommodate the new borrowers in the private bank’s and NBFC’s respective pools, both lenders had to increase their interest rates to compensate for adverse selection and moral hazard.
On March 14th, 2018, Urjit Patel, the Governer of the RBI, expressed that “the emerging risk to the financial sector is [the] increasing trends in frauds in commercial banks and financial institutions. During the last five financial years, frauds have increased substantially both in volume and value terms. During this period, […] the volume of frauds has increased by 19.6 per cent.” With the PCA in action, default rates may decrease in the future in the public sector, but the influx of borrowers turning to private bank’s and NBFC’s may find higher interest rates unmanageable. In that sense, some borrowers will be left behind due to the crowding out problem.
Dhillon, D. (2018, April 09). India’s small businesses are suffering from a shortage of credit options. Retrieved from https://www.businessinsider.in/indias-small-businesses-are-suffering-from-a-shortage-of-credit-options/articleshow/63683278.cms
MSME Pulse Report (2018, March)
Patel, G. (2018, March 14) Inaugural Lecture: Centre for Law & Economics, Centre for Banking & Financial Laws
Stiglitz, J. (1975). The Theory of “Screening,” Education, and the Distribution of Income. The American Economic Review, 65(3), 283-300. Retrieved from http://www.jstor.org/stable/1804834