Impact of unsecured business loan on Indian economy

Capital is the lifeline of any business be it a small scale enterprise or a large organisation. Businesses largely survive on a dependable source of financing to run their operations whether it be working capital requirement or for investing in a long term project. Any capital comes with a cost that includes a risk value as well as time value. Mostly, loans which have short repayment tenures are favoured by companies since they come attached with a lowered cost of time value. But under cyclical conditions they start costing more than long term loans due to inverted rate structures. This could be due to inflationary pressures or in special circumstances because of paucity of funding available in the market.

Since short term loans tend to be unsecured they happen to cost effectively more due to the risk value attached as they are not secured by any collateral. Banks and financial institutions are required to provision for bad debts and business loan disbursements in any circumstance since these loans come with a risk of default. A default on an unsecured loan would mean no guarantee of payment and can cost the bank or the financial institution a complete write-off. Since a non-banking financial corporation is not allowed legally to take deposits like a bank, it cannot depend on interest rate differentials (on deposits and loans) and hence gets no arbitrage to cover its losses leaving it exposed completely. It thus creates a systemic risk that can lead to domino effect on the economy. To keep themselves capital adequate as per the reserve bank regulations, they resort to package these unsecured loans in off balance-sheet structures and sell it to mutual funds. Since these loans cannot be traced back to the origin source, the credit rating agencies are not able to effectively price the risk to the originating company. These off-balance sheet investments cause cause further damage which in turn hurts investors, market sentiment, capitalisation of companies, govt and foreign investments.
 
An economy of a country is always effected by cyclical upturns and downturns. In a rare case of default by a NFBC due to the failure of its big debtors to repay off their liability or a substantial chunk of its loan turning non-performing, it can create a havoc on the economy. When any NBFC turns into “ A Too Big To Fail” behemoth, it can have financial ramifications that affect each and everyone in the economy. Banks become circumspect to lend fresh loans as they do not get to know which company is holding what in its off balance-sheet investment. This completely chokes the system of any new funding and unnecessary increases the cost of capital. The benchmark lending rates do not trickle down to the consumer segment since managing NPAs and provisioning for them takes precedence. This causes capital impairment, which deters banks from extending further fresh loans.   

Government comes under the pressure to save these institutions from collapsing. The government starts nationalising losses by diverting funding to these institutions. In Indian scenario, the government eased NPA loans and effectively turned financing these distress institutions into the priority sector lending club. These leads to a vicious cycle where absence of funds dry up in productive sectors like infrastructure and thus limits the additional capacity creation. This itself is inflationary in nature and ties up the reserve bank’s hands from further reducing interest rates in the long run. Under inflationary conditions, people tend to spend less thereby affecting the growth of the economy. 

Over the years, RBI governers have traditionally taken a hawkish stance. That is, they tend to focus more on inflation than growth. In a forced circumstance like India faces with the default of financing institutions and housing finance companies, even bringing down interest rates leads to more inflation as there is more money in the market with no long term capital investment spending. Since the entrepreneur stops making new investments, forget taking a leverage by getting a business loan, it brings the economy to a standstill. Under these turn of events, the economy is not able to produce more jobs effectively traumatising the consumer spending that is supposed to take on the slack of the absence of capital investment. 

Large non-banking finance corporations are a systemic risk to the economy. Even though they work to fulfil an essential gap in the market, they should come with the right checks and balances so they do not cost the taxpayer in case of a big default. Business loans are by far the most effective way to support the entrepreneur into making productive investments. Even if they are unsecured, they can be securitised in a more transparent manner. However, unsecured loans eventually will have to be gate-walled from affecting the real economy. One of the many options is a liquid corporate bond market where the risks are properly disclosed so that a private investor who is intent on making money from the risk cannot be allowed to depend on the government to take on the tab.  

Indian Government has taken many steps like easing liquidity, lowering interest rates, special on-lending to NBFCs, announcement of 10 percent first-loss guarantee to state-run banks for their purchase of securitised assets of NBFCs which are highly laudable but they do not mitigate the extent of damage that off balance-sheet investments can cause or the exposure taken by mutual funds can havoc. India is not prepared to take on a Lehman like event because that will cause a loss of reputation in the international market and foreign funding that keeps our stock markets liquid. We are not prepared to take on a currency shock (or fall of currency reserves) if foreign funds dry up, as this will make our exports uncompetitive in the international markets and affect another growth engine that makes our economy the most productive economies in the world. And more importantly, let’s not make an entrepreneur who is risking it all by taking the business loan face the penalty of back-breaking high interest rates.

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