The RBI Committee on Comprehensive Financial Services for Small Businesses and Low-Income Households (CCFS) lays out several recommendations to strengthen the supply side with respect to credit outreach through the banking and non-banking infrastructure that is already in place. It emphasises that the provision of credit to remote or difficult-to-serve customers must be cognisant of risks involved or the cost-to-serve considerations so that viability of the entire channel can be sustained and that profitable models are given the freedom to evolve. The recommendations broadly push for a new direction to existing efforts, one that shifts away from the current approach of requiring all entities to engage in all activities, to an approach where multiple entities are permitted to specialise in chosen activities and regions and also of establishing a nurturing environment that promotes partnerships between these multiple institutions. We discuss some of the important recommendations in this context over two posts, this being the first.
Credit delivery through national full-service banks has been the channel of choice for India, besides the much smaller contributions by channels such as regional banks and non-bank finance companies, all of which are RBI –regulated (and supervised by NABARD and State-level bodies as is the case with rural Cooperative Banks). Full-service banks have incurred high costs of operations in the process of servicing small ticket loans, loans for which the interest rates have been traditionally maintained within limits as a policy prerogative. The policy also mandated such loans to be originated on the banks’ own books and through its own branches, and to be necessarily held to maturity, resulting in high costs and risks to the portfolio, and poor financial health outcomes. The CCFS Report makes the case that such national institutions must be allowed to manage costs and risks actively and the way to achieve this is to remove prescriptions of all kinds such as pre-set low interest rates irrespective of underlying risk (sometimes below Base rate), interest rate subsidies from the Government, and mandated provision of food credit and so on. The Committee reiterates that banks should be free to price their farm loans based on their risk models and the permission to price them below the Base Rate must be withdrawn. Government benefits such as interest subventions and debt waivers may be transferred directly to the farmers without channelling them through the credit system. Risk-based pricing is also recommended in the manner of DICGC’s pricing of deposit insurance that banks avail.
To improve outcomes, there is a need for increased transparency of banks’ balance sheets, through public reporting of stress test results at least on an annual basis. Also given that high branch costs are not amenable to the delivery of rural credit in difficult-to-reach districts, these institutions must be permitted to set up dedicated subsidiaries (such as with low-cost structures) that specialise in this activity and no longer rely on a centralised loan processing system followed by such banks. National banks can play a far more effective role as risk aggregators given their size and instead of originating on own books, be permitted to purchase assets from other institutions that exhibit high-quality origination capability (but who do not have the capacity for risk aggregation). The Committee in this context recommends policy approaches that support the development of robust markets for the active transfer of assets, liabilities and risks between financial institutions. Such markets will facilitate the sale and purchase of assets (including PSL assets to meet PSL targets) between all types of entities, in a manner that is based purely on the quality of assets originated and is agnostic to institutional differences, while also keeping incentives aligned through capital commitments and loss default guarantees.
The Committee reiterates the need for universal reporting to credit bureaus of all loans and by all originating entities, including for SHG loans, Kisan Credit Card, and General Credit Card facilities, so as to mitigate any moral hazard and also to allow high performing rural borrowers to signal their credit worthiness and thus be given the chance to obtain both lower cost and higher quantum of credit. Such a step has been successfully implemented in the context of NBFC-MFIs already. In the absence of credit history data, frameworks that incorporate alternate transaction data of the customer’s creditworthiness such as that from telecom companies and electrical utilities must be explored.
Unlike national banks, Regional Banks, as the CCFS report explains, are well-suited to meet the challenge of last-mile delivery, but have a well-documented history of governance problems, but also most importantly the lack of capability to handle regional level systematic risks such as rainfall shocks and local-economy related events such as commodity-price fluctuations which have adverse effects on asset quality. There is a need for banks to protect their entire rural lending portfolio against such shocks through the purchase of catastrophic portfolio insurance so that in the event of such a shock, a Government bailout (that also severely distorts credit culture) would no longer be the only option. Commodity price risk should be hedged with insurance or commodity put options bought by banks on a wholesale basis from global options markets since such markets do not exist in India.
While risk-based supervision has already begun to be undertaken for commercial banks, a similar system can be put in place for regional banks by subjecting themselves to rating by rating agencies, the results of which are publicly disclosed. This will help the stronger institutions to perform better while also incentivising the weaker ones to improve their performance. The CCFS report suggests that the risk management in these banks be significantly strengthened before they can be relied upon as a valuable channel for credit delivery. In this regard, the Committee proposes an enhanced role for Development Finance Institutions such as NABARD, NHB, SIDBI, and CGTMSE, moving away from their current focus of providing automatic refinance (thereby absorbing the associated risks on their own balance sheets), to providers of fairly priced risk-based credit enhancements to better-performing institutions.
A subsequent post will delve on recommendations pertaining to non-banking entities engaged in credit delivery and their role in covering the last mile between banks and the end-borrower.