Transition to loan system: The craft lies in tailor-making

Asish Saha

Moneycontrol Contributor

Commercial banks in India provide working capital via an array of facilities of which cash credit (CC) is the most popular mode of financing. Despite its popularity, cash credit poses various regulatory challenges like perpetual rollovers, transmission of liquidity management from borrowers to banks and it impedes the smooth transition of monetary policy.

The regulatory nudge

Given these challenges, the Reserve Bank of India issued draft guidelines on “Loan System for Delivery of Bank Credit” for comments on April 5, 2018, for public comments. The final guidelines were released on December 5, 2018. The said regulatory nudge would result in the transition to an era where banks would practice a combination of cash credit and loan system from April 1, 2019, to meet the working capital requirements of borrowers with a limit of Rs.150 crores and above. It is expected to herald a new phase in the banker-borrower relationship. In this write-up, we provide a holistic analysis of the key issues involved in the financing working capital requirement by CC. In this process, we highlight the various feature of this lending product and a combination thereof can be tailored to meet the needs of the borrowers, the banks as well as the regulator.

Features of the Cash credit system

The Cash credit system has its origin in Scotland and we adopted it in our country as it was in tune with the prevalent ‘security-based’ lending system to finance trade. Over time, though manufacturing became the key drivers of growth in India, cash credit system continued to remain as the key lending product of banks. In principle, the cash credit system is a pure funding facility. Once approved by any bank or consortium of banks, by contractual obligation, it is expected that all the inflows and outflows resulting out of the operations of the borrower would be routed through the account. Hence by design, the banks not only had to handle all the transactions arising out of the borrowers’ business but also provide ‘cash management’ services. It is the net-flow which stands as the ‘outstanding’ in the cash credit account of a customer on a day-to-day basis which forms the basis for the computation of interest to be charged for the utilisation of limits. In the absence of any specific repayment date, the cash credit limit has in effect become a perpetual limit. The inherent difficulties to verify the end-use of the fund, it is also used by borrowers to fund their long term requirements. Moreover, in the absence of any commitment charge, the borrowers have the liberty of drawing down the limits as and when needed by them posing challenges to the asset liability management process of banks. Though the Treasury Department of banks has the mandate to manage the ebbs and tides of the flow of funds on a day-to-day basis, the implicit cost of the cash management services gets subsumed in the interest rates charged by the banks. The pricing of cash credit facility, therefore, failed to reflect the true nature of all the implicit and explicit funding and service components of this relationship. The interest rate charged by banks remained as a ‘bundled offer’ and failed to respond to the changing stance of the monetary policy pronouncements of the RBI from time to time.

The Reality check

An analysis of the pattern of utilisation of limits by borrowers enjoying limits in different size categories and across industry groups would reflect that in large exposures (beyond Rs.150 crores) range between 25 to 50 percent. Moreover, quite often the utilisation of limits by very large and high creditworthy customers  remains at near zero levels for the most part of the year with occasional blips when the limit get utilised to the fullest extent.  In relatively smaller exposures (Rs. 50 to 150 crores), the utilisation varies between 60 to 80 percent and in accounts having limits below 50 crores, it varies between 80 to as high as 95 percent.  It would, therefore, be safe to conclude that the undulations and hence the ‘option risk’ implicit in cash credit facility made available to large borrowers is high.

The utilisation pattern as presented above supports the stipulation of RBI when it expects that from April 1, 2019, atleast 40 percent of the limit be made available in the form of a working capital loan by banks to borrowers enjoying limits of Rs. 150 crores. It also supports the stipulation that banks should gradually slide the scale to 60 percent from July 1, 2019. The commitment charge for the unutilised portion of the limit may usher more lending discipline. Moreover, the capital adequacy implication of the unutilised limit is expected to improve the prudence in lending decisions and sharpen the limit fixation exercise by banks.

The new design & benefits

Transition to the working capital loan mechanism would require a more open and transparent        banker-borrower relationship. It would also require a significant upgrade in the credit assessment skills of banks in structuring working capital loan facilities to individual clients. While negotiating the line of credit for any particular year, apart from the projected financial statement for due diligence, banks would require the borrowers to submit their projected cash budget.  Assuming the level of utilisation of limit represent the cash gap projected by the borrowers, the peaks and troughs would provide a clear indication of the sizes and tenure of short-term self-liquidating working capital loans that could be sanctioned by banks in each of the accounts. In an era of GST, it would be worthwhile for banks to curve ‘bills limits’ within a cash credit facility to ensure the proper end-use of funds. In the process, banks would also be able to put in place a more transparent and credible credit monitoring mechanism.  The borrower should, however, have the freedom in choosing a single plain-vanilla, or, a basket of the same, or, cash credit, or a combination of all such facilities that might suit their requirements. The sanction of a fresh new limit before the repayment date of any loan component would facilitate the exchange of information between the borrower and the banker. The cash credit limit may act as a top-up facility with one year tenure which may be renegotiated at the end of each year. In addition, banks may like to offer working capital loans at a cheaper rate than cash credit in their effort to entice the borrowers to reduce the ‘option-risk’. A robust pricing mechanism would become the hallmark of the success of the proposed transition.

Concluding note

Tailoring of each facility to the projected cash gaps in each account would not only result in mutual benefits to both borrowers as well as banks, but it would also be more sustainable. It would also facilitate a smooth move-over to a robust market sensitive loan pricing mechanism of banks aligned with the changing monetary Policy stance of the Reserve Bank of India.

The author is Professor of Finance, FLAME University and former Director, National Institute of Bank Management, the apex institution of Banking and Finance set-up by the Reserve Bank of India, for over a decade.

*Views expressed in this article are personal.