India’s small businesses could escape their short term financing issues

• Piyush Goyal, India's interim Finance Minister, is planning to ask the Reserve Bank of India to ease the restrictions it has imposed on 11 public sector banks.
  
• Goyal met the top management of these 11 public sector banks in Delhi yesterday.
  
• If he succeeds, micro, small and medium enterprises in India will benefit.

Piyush Goyal, who has been given temporary charge of the finance ministry until Arun Jaitley recovers from a kidney transplant surgery, has swung into action. Yesterday, Goyal met the heads of 11 public sector banks in Delhi.

If Goyal has his way, the small and medium enterprises in India could get a respite from their credit shortage in the near future. The finance ministry is reportedly planning to ask the Reserve Bank of India (RBI) to ease lending restrictions imposed on the public sector banks under its Prompt Corrective Action (PCA) framework.

Goyal is said to have instructed the top management of these 11 banks to formulate a recovery plan, one that is expected to include deadlines and targets for loan recoveries, asset sales and risk reduction.

After meeting the heads of Dena Bank, Allahabad Bank, United Bank of India, Corporation Bank, IDBI Bank, UCO Bank, Bank of India, Central Bank of India, Indian Overseas Bank, Oriental Bank of Commerce and Bank of Maharashtra, Goyal told media outlets that the central government would extend all the support to strengthen the banks placed under RBI’s PCA framework so they could revive their lending operations.

What is RBI’s Prompt Corrective Action framework?

The RBI introduced the PCA framework to impose restrictions on lending, as the earnings of banks declined and their bad loans piled up. The public sector banks had nearly ₹7.8 trillion worth of bad loans at the end of 2017, over 90% of all total bad loans among India’s banks.

Eleven out of India’s 21 government-owned banks, including IDBI Bank, Indian Overseas Bank and Oriental Bank of Commerce, are on the central bank’s watchlist due to their high level of non-performing loans and declining earnings.

The PCA framework not only imposes restrictions on credit, but also on capital expenditure, salaries for senior managers and mandates higher provisioning for defaulted loans. In a worst case scenario, the RBI may even ask a weak bank to merge with others.

How the PCA framework affects small businesses

The restrictions imposed on the public sector banks directly affect the flow of credit to small businesses, which are estimated to account for 38% of India’s GDP.

Micro, small and medium enterprises derive a little over 55% of their financing from public sector banks, which are mandated to provide cheap financing to them under the government’s priority sector lending guidelines. However, the credit options for these firms have dried up, not only due to a series of banking frauds, but also as more lenders have been placed under the PCA framework.

Last week, the RBI imposed further restrictions on Dena Bank, which was already on its watchlist. This included a total ban on all lending and hiring. The move followed the release of Dena’s financial results for the year ended March 2018. Its net loss widened to ₹19.2 billion while its bad loans reached a staggering ₹163.6 billion. If the bank’s financial situation deteriorates, it could be liquidated. A few days earlier, the RBI imposed similar restrictions on Allahabad Bank.

In order for banks to be taken off the watchlist, they need to be profitable for a period of two years. Goyal is likely to ask the RBI to amend the conditions for removal of these 11 banks from the list or at least to ease the lending restrictions currently in place.

The government and RBI have slightly conflicting interests here. While the former wants to make sure small businesses meet their financing needs, the latter does not want to encourage further lending, the very purpose of their existence. While a shortage in lending to SMEs will jeopardise India’s economic growth, the premature easing of restrictions on India’s public sector banks could send their balance sheets into a further tailspin.

However, India’s GDP growth in the short term might just be worth a delay in the revival of these banks. It is election year, after all.