India’s small businesses are suffering from a shortage of credit options

• As of December 2017, public sector banks accounted for 55.4% of all loans to micro-small-and-medium sized enterprises.
  
• However, half of the country’s public sector banks are on the RBI's Prompt Corrective Action (PCA) watchlist, which involves the imposition of credit limits.
  
• As a result, funding for small businesses is harder to come by. They will have to the turn to the private banks and non-banking financial companies in the meantime.

Following the twin hits of demonetisation and the GST, India’s small businesses have another problem to contend with: a dearth of credit options. This is largely due to the credit limits that the Reserve Bank of India has placed on half of the country’s public sector banks through its Prompt Corrective Action (PCA) framework.

As of December 2017, public sector banks accounted for 55.4% of all loans to micro-small-and-medium sized enterprises (MSME), according to a report by Transunion CIBIL, a credit information firm, as well as 79% of all loans less than ₹1 million to new borrowers. State-owned banks are an important source of cheap financing for these businesses, especially since the MSME segment is a priority sector under government guidelines.

However, funding is harder to come by for this segment. As a result of a pileup in non-performing loans, 11 of India’s public sector banks are currently placed under the Reserve Bank of India’s PCA programme. Banks are added to the watchlist once they cross a certain risk threshold for bad loans, return on assets or capital adequacy.

All the banks on the watchlist, which includes the likes of IDBI Bank, UCO Bank and Oriental Bank of Commerce, have non-performing loan ratios in excess of 15%, which means more than 15% of their outstanding loans are unlikely to be recovered.

Under the PCA framework, which was revised in April 2017, the major activities of banks are curtailed by the RBI. The programme imposes restrictions on lending, risk-weighted assets, branch expansion, capital expenditure and compensation of senior managers as well as higher provisions for loan losses.

The restrictions are meant to discourage profligacy, encourage tighter lending standards and restore the financial health of a bank. However, being sanctioned under the framework does not necessarily translate into an improvement in performance. India Overseas Bank was put on the watchlist in October 2015. It’s non-performing ratio has swelled from 12.6% at the end of 2015 to 22% at the end of 2017. The bank’s net loss also widened to ₹34.2 bilion at the end of fiscal 2017, from ₹29 billion the previous year, partly on account of higher loan provisions.

Hence, it’s quite likely that some of the banks on the PCA watchlist will have to deal with credit limits for a long time.

An additional 5 public sector banks are expected to be added to the PCA watchlist soon, according to ICRA, a ratings agency.This is unfortunate. Small businesses reportedly account for 40% of India’s GDP and are a major engine of job creation. Their growth, and consequently, India’s growth depends upon access to a sufficient amount of financing from state-owned lenders. To make matters worse, they’re often perceived as a riskier bet than larger businesses, which don’t rely on banks for funds as much their smaller counterparts owing to their access to bond markets.

The Indian government’s ₹2.11 trillion recapitalisation plan, which was announced in October last year, is envisioned as a solution to this problem. The first round of the plan involves the allocation of ₹523 billion to the 11 banks on the PCA watchlist. While this is a step in the right direction, it will likely be a while before small businesses benefit from the increased liquidity at these banks.

The bulk of the invested funds will primarily be used to plug the holes caused by large non-performing accounts in these banks’ balance sheets. Additionally, as part of a complementary set of reforms, smaller public sector banks have been asked to reduce their lending to corporate clients, which includes small businesses, and increase their retail lending.

The private sector is looking to fill the void in the meantime. According to CIBIL, private banks have increased their share of loans to the MSME sector from 25.4% to 28.4% from December 2015 to December 2017, while non-banking financial companies (NBFCs) have increased their share from 7.9% to 10.4%. There are also a growing number of startups that are focusing on lending to SMEs such as Instamojo, Namaste Credit and Lendingkart.

However, in turning to the private sources, the MSME segment has to deal with higher rates of interest and stricter norms. While this might reduce the rate of defaults, a lot of small businesses will be left behind.