India’s central bank is imposing credit limits on large corporate borrowers to prevent further defaults

On June 11th, the Reserve Bank of India (RBI) released a number of draft guidelines aimed at ensuring discipline among large corporate borrowers. The move is the latest in a line of corrective steps that the central bank has taken to prevent fraud and avoid further pileup of non-performing loans at India’s banks.

The rules largely pertain to companies that have a working capital facility, or a continuous credit line, from India’s banks. The RBI is looking to limit the amount of cash credit a business can avail of for its short-term financing requirements so as to discourage the misuse of such a facility.

For example, Nirav Modi and his associates got Punjab National Bank to issue letters of undertaking (LoU) for the stated purpose of financing their companies’ day-to-day import operations. These LoUs enabled Modi to obtain short-term credit from the foreign branches of Indian banks, which they eventually defaulted on.

A minimum loan component

In addition to curbing fraud, the RBI wants to prevent growing companies from borrowing beyond their means. Hence, it is reducing the amount of working capital available to large borrowers in the form of “cash credit”, or cash issued freely against collateral, and increasing the term loan component, wherein funds are released in stages and are dependent on the borrower complying with a strict repayment schedule.

From October 1st onwards, the RBI has proposed that for borrowers with a credit line of ₹1.5 billion, at least 40% of the sanctioned credit must be in the form of a “term loan”, with the remainder issued in cash credit or another flexible arrangement. The central bank plans to increase this 40% minimum loan component to 60%, starting April 2019.

As term loans involve pre-determined repayment schedules, banks will benefit from regular payments on the short-term loans extended to borrowers. The RBI has allowed banks to set the terms of loan repayment with borrowers - be it in instalments or a lump sum.

Since cash credit offers greater freedom to borrowers in terms of repayment terms, it is the most popular form of short-term financing for companies. However, it allows rollovers and delays from the borrower’s side. In addition the limits mentioned above, the RBI has also directed banks to reduce their risk by setting greater provisions against the unused cash credit component of a loan.

The stricter norms will make companies wary of extending their credit lines in the immediate term. Additionally, by primarily focussing on large borrowers, the RBI is sparing India’s small businesses - which are considered to be the growth engine of India’s economy - from a reduction in their credit options.