Corporate Lending – Evolving Cash Flow Based Lending
India’s growth rate in 2018 is projected to hit 7.30% and 7.50% in the next two years, according to the 2018 Global Economics Prospect (South Asia) report released by the World Bank in January 2018
As per World Bank report May 2017 on India Economic Update, private investment in the country continues to face impediments in the form of corporate debt overhang, stress in the financial sector with rising NPAs, excess industrial capacity, and regulatory and policy challenges. Private investment, which accounts for 75% of total Gross fixed capital formation (GFCF), has not been forthcoming despite the promise of crowding-in by public sector investments and government efforts to improve the business environment and facilitate foreign direct investment (FDI). Private investment is expected to pick up but only gradually as recovery may be protracted, and one of the causes has been corporate leverage and the persistent weakness in credit growth.
Recent reports also suggest that corporate investments in India are at 13 year low with manufacturing sector facing the sharpest fall in new project announcements. Despite all these, a blessing in disguise is that India’s growth rate in 2018 is projected to hit 7.30% and 7.50% in the next two years, according to the 2018 Global Economics Prospect (South Asia) report released by the World Bank in January 2018. Private investment is expected to revive as the corporate sector adjusts to the GST; infrastructure spending increases, to improve public services and internet connectivity; and private sector balance sheet weaknesses are mitigated with efforts of the Government and the Reserve Bank of India. However, to materialize its potential, India needs to take steps to boost investment prospects.
According to RBI quarterly data of December 2017, the gross bank credit to industry (Micro & Small, Medium & Large) was Rs.26.34 lakh crore and it reflected contraction of 1.70% as compared to March 2017. Apart from increasing Non-Performing Assets (NPAs), high-interest rate scenarios, global uncertainties, various measures by central government and regulator’s impetus on the growth of bond market have reduced corporate India’s credit dependency on banks. Corporates have been increasingly meeting their funding requirement from bond markets instead of from banks. As per reports, the corporate bond issuances rose to a record high of Rs.6.70 lakh crore in FY 17, registering a growth of 36% year-over-year. The incremental bank credit, on the other hand, grew by 8.7% (Rs.6.3 lakh crore) during the same period. The bond market also getting preference due to faster transmission of rate cuts by RBI compared with banks.
Banks also facing recently introduced large exposure framework in the form of specified corporate borrowers. Under these guidelines, a specified borrower is one having an aggregate fund-based sanctioned credit limit (ASCL) of more than Rs.25,000 crore as of end of FY 18, reduced to Rs.15,000 crore for FY 19 and Rs.10,000 crore for FY 20. The normally permitted lending limit (NPLL) for the specified borrower would be 50% of the incremental funds raised by the borrower over and above the ASCL. Banks will need to provide higher capital provisioning for exposure to these large borrowers and lending above NPLL would attract higher provisioning with high-risk weights.
In these restricted circumstances wherein at one end undesired market sentiments (rising NPAs, frauds, low growth sentiments etc.) are affecting lenders confidence in improving corporate lending, while on the other end development of substitute markets (Bonds, CPs, PEs/VCs, PE/VCs in the form of Debt Structures, and even growing IPO market etc.) are providing other avenues to the corporates in shifting from bank credits, which forces us to rethink, revisit the corporate lending strategy and evolve a more efficient lending practice.
Myth or Reality of Collateral
The low corporate credit growth has not remained unnoticed in regulatory and government circles. Government and regulators have shown efforts in creating a low-interest rate environment in order to push corporate India taking up expansions with the advantage of low-interest rate regime (this party appears to be over with RBI’s recent hawkish stance under the increasing inflationary environment and leading banks slowly increasing lending rates). High level of NPAs have at one end created issues related to capital shortfall at banks while on the other end hard recovery measure exercise has kept bankers fully engaged. In this situation, banks appear to be following a cautious approach and more focusing on retail lending along with other cross sell of products for improving the business and margins.
A prima facie analysis of lending practices of banks provide that banks have been increasingly focusing on consortium/MBA lending based on collateral comfort while considering corporate funding. The asset coverage ratio based on collateral forms one of the major factors in risk assessment during appraisal of financing proposals. It has been proven that despite the comfort of collaterals, recovery from NPA cases has not been easy, it requires fighting long legal battles, and despite that the recovery percentage remains to be quite low. These results force us to a conclusion that comfort of collateral if not has been proven myth then it has also not been proven realistic also. Taking possession of an asset/property and then selling it off requires a different spirit and skill set which has not been at least forte of bankers. With the progress of Insolvency and Bankruptcy Code (IBC), the resolution of NPAs now although appears to be time-bound, however, this route is still evolving and yet to prove its success.
The Valuation Dilemma
While entering the transaction based on collateral, quality of assets play important factor and lot of attention is given to the due diligence on the assets/properties offered. Apart from title clearance, prior encumbrance, valuations are gazed in terms of Fair Value, Distress Value and Realizable value of the assets. No doubt to say that in such transactions, the due diligence involves significant costs and efforts. However, the huge manoeuvre despite following all the cautions taken, many a time results inadequate. It is observed that the so hyped assets at the time of their liquidation/auctions do not fetch the required valuation or even reach close to the same. The recent experience of the low bids offered under NCLT for various cases under the resolution, reflecting hair cut by lenders of up to 80% - 85% is a fresh example on this front. There could be several attributes for the same including the underdeveloped market for the sale of such stressed assets, cartelization, deterioration, encroachments or haywire initial valuation, commodity cycle issues, shortage of professionals/agencies etc. But the moot point is that when these aspects of collateral-based lending are known then it is important for the lenders to look at the other ways of timely repayment of dues instead of over-reliance on a collateral based lending which has not been proven at least as a most successful tool in corporate lending.
Competition, that ruins
In the corporate lending arena, when there are acceptable, reputable transactions, lenders compete to grab the business. Good competition is healthy in any field, it benefits the customer, drives innovation, and improves value, however over competition make lenders bleed not only in terms of lowering down the asset coverage but also the account profitability. Hence, in corporate lending, this fact is also encashed by borrowers and collateral coverage becomes a hard point of negotiation. It is experienced that many a times the commercial terms play a secondary role while asset coverage performs a key role for a corporate borrower in finalizing the lender(s) for the transaction. Corporates are seen in heavily bargaining to lower down the collateral cover which to some extent makes the model of collateral-based lending futile. Competition on this factor ruins the basic foundation of collateral-based lending.
No timely/freely possession
In case of default, liquidating the primary and collateral security apart from resorting to encashing pledged assets, corporate guarantees or personal guarantee are the difficult options available to the lenders excluding some easy options of encashing liquid assets (most of the time of meagre as compared to the amount of debt involved). Taking possession of the primary or collateral securities has never been proven as duck soup. The present legal system requires due procedures in the form of notices etc. to be strictly followed before taking the possession of the properties. Nothing below perfection works on this front. Smallest error leads to painful delays in stretching the possession cycle and recovery. The overburdened legal system further elongates the recovery cycle. The borrowers have shown smart moves by creating legalized encroachments in the forms of creating tenancies and finding minute loopholes in SARFAESI/DRT applications, notices/actions. Due to these tactics of borrowers, even SARFAESI Act has not been able to much aid lenders in getting timely possession of mortgaged assets. Again, all these facts force us to rethink on the collateral based lending and visiting other business models for decisive corporate lending.
Business Strategies and CFL
There have been various business strategies in Corporate lending followed by lenders. While banks with large balance sheets have shown appetite for taking large exposures and have been also daring to play long-term (even at the cost of playing with asset-liability mismatch risk), NBFCs have shown practicing art of quick entry and timely exit (mostly of short-term play) with compromising on collateral covers but snatching from banks the opportunity of making good profit margins. Some lenders specially banks have been financing greenfield and brownfield projects of manufacturing sector, infrastructure sector or asset-backed lending, some other lenders specially NBFCs focus on specialized financing activity like equipment finance, auto finance, bill discounting, factoring, commercial real estate projects, housing finance, SME financing etc. Recently, in India, some lenders have been also adopting lending practices based ESG (Environmental, Social and Governance) factors. And there is a mix strategy also combining diversification in each/some of the above plays.
These specialized segments are also a kind of partial diversification then full reliance on collateral-based lending model because in these business models the lenders find some indirect ways of controlling the assets or cash flows, or diversify the risk to a larger base of borrowers. Each strategy has its own positive and negative repercussions in the form of growth dynamics, profit margins, scalability and risk levels, and adopted based on lender’s command in understanding the segment and capacity/resourcefulness in the timely recovery of dues. Auto loans (commercial and personal) is a good example in this direction where some lenders have apparently shown their good expertise in the segment.
Focusing on Cash Flow Based lending (CFL) is one of the business strategies which is gaining traction in the aftermath of deficiencies reflected in the asset-backed/collateral-based lending. While in asset-based lending, the valuation of collaterals offered mainly decide the loan amount and tenor, in CFL it is the net cash flows of business which are the key focus and based on their availability for repayment, the loan amount and tenor are decided. In several studies, it has been supported that CFL is considered to be a more appropriate strategy for MSME sector given that non-availability of collaterals by borrowers in this industry.
However, CFL may be considered to be a suitable route even for larger exposures also with some upliftment. There are various examples which prove the success of corporate lending based on CFL. Some of these examples (wherein cash flows have been the key essence of lending) include Lease Rental Discounting, Toll based Project Finance, Firm Order based Lending (especially in Export Finance), Ware-House Receipt Finance, Vendor Finance etc. There could be issues in large-scale CFL also, related to its key reliance on rightly forecasting the cash flows based on the data/information provided by the borrower. However, when the lenders focus on CFL as a key strategy, they can ring fence the entire cash flows of the corporate leaving no room for diversion of funds. One of the root causes experienced under the asset-backed lending strategies has been the diversion of cash flows through various banks accounts. Hence, when the key area of monitoring becomes cash flows instead of collateral, it is but obvious that no compromise would be allowed on any leakages on this front.
In the recent times, it has been voiced that banks being dependent on short-term funds, therefore they find difficulty in financing of infrastructure projects, and hence need has been expressed for institutions/sources/funds having capability to take long-term exposures. Within the context of CFL, it can be well appreciated that cash flow access is bread and butter for banks and once a project achieves commercial operations satisfactorily, it graduates as a fit case for CFL. The point to be stressed here is the need for change in focus of lending strategy from asset-based to CFL backed. At the time of refinancing in such cases, lender would be more focused on ring fencing of cash flows then the asset coverage availability. Many borrowers have suitably taken the advantage of CFL in BOT based road projects by refinancing of the loans after achieving commercial operations. The recent announcement by government about Toll-Operate-Transfer (TOT) based road projects is a straight example of CFL gaining firm ground as lending model. Real Estate Investment Trust (REIT) and Infrastructure Investment Trusts (InvIT) are also the innovative examples of lending based on the reliance on cash flows.
It is not that project specific/SPV based businesses are the few options which can be successfully implemented under CFL. As said earlier, lending to MSME has already been accepted through CFL. The recent successful growth of fintech companies in the area of micro/small/SME unsecured lending further firms up this belief. It is only the change in strategy having a focus on ring-fencing of cash flow and sharpening of skills and tools in appropriately forecasting the cash flows which are needed to develop a successful CFL strategy. Banks are already familiar with the Escrow Account and Trust & Retention Account (TRA) structures. However, these are either more adopted in restructured accounts or loosely monitored in other cases (project finance) (since focus of lending being the asset backed instead of cash flows). These structures can be adopted with firm belief and focus on fully controlling the cash flows of the corporate borrower even in case of consortium or multiple banking based arrangements.
It is expected that when focus would turn to ring fencing of cash flow, it would automatically require lenders strengthening the resources for the same which may be in the form of cash flow audits, concurrent audits, cash flow analysis, improved turnover monitoring among consortium lenders, internal analysis/reporting of turnovers, higher manpower deployment, or some other innovative methods etc. All these are expected to strengthen the grip on cash lows and thereby leaving no room to the borrower for diversion of funds/misrepresentation of business performance.
One of the dilemmas faced in consortium/multiple banking arrangements is that all the lenders want their pie in sharing of the turnover by the borrower. Although the spirit has been that everyone wants to monitor the turnover, and borrowers also try to comply with the same by allocating a part of payments from their regular clients to the respective lenders. Share in turnover also attracts importance for the banks from having access to free float of funds. However, this situation also leads to the difficulty that at any moment no lender is in a position to exactly understand the total turnover of the borrower. The situation also provides room to the borrowers in creating fictitious turnover by transferring funds from one bank to another and creating trail of hundreds of transactions thereby making it complex to understand the exact turnover. Although TRA mechanism could be best solution to be implemented in all accounts however considering the time and efforts required in such arrangement, lenders may at least prefer to implement Escrow account arrangement wherein they can mutually agree that all the turnover of the borrower is strictly routed to one account with lead bank and from there only funds are later routed to other consortium lenders. Such arrangement is expected to aid in better ring fencing of cash flows of the borrower.
With the advent of technology in the areas of data analytics, artificial intelligence, and strengthened IT infrastructure in Indian banking system, new improved lending practices needs to be embraced. The advantage of Collateral-based lending cannot be negated. However, benefits of cash flow controlling is the need of the hour in order to keep the momentum in corporate lending. With a shift to key focus on cash flows, lenders can better assess the repayment capacity and liquidity position of the corporate clients and regain confidence in corporate lending. A shift in this direction may lead to the introduction of new structures like ToT, REIT, InVIT or some other innovative models, but for that shift in this direction is required. Yes, combining of collaterals as a backup tool could be supportive but not as the critical reliance factor of lending strategy.
Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.