TRANSITION TO CASH FLOW-BASED FUNDING

HISTORY

The Indian
banking industry is centuries old. A peep into its recent past is replete with
milestone events of change. Notable among them, starting with social control
over banks, have been nationalisation of commercial banks; identification of
priority sector for lending; an annual credit plan; diversification of
institutions and setting up of the Exim Bank to focus on export financing;
regional rural banks to introduce the hybrid of commercial bank strength with
local government participation; the creation of local area banks; micro-finance
companies; and so on. Clearly, banks have been an important tool to facilitate
the development of the Indian economy for decades. Foreign direct investment
norms in the banking sector were relaxed and the cap raised to 74%. The
financial needs of the rapidly-growing economy were catered to by government
banks, private banks and foreign banks, with a major share taken by government
banks. The Reserve Bank of India (RBI) issued guidelines for banks and ensured
compliance of BASEL-I norms in a phased manner between 1991 and 1999.

The growing economy needed more
finance and advanced banking. The ever-increasing need for strengthening of the
banking sector was further underlined as Lehman Brothers collapsed in the
Sub Prime Crisis (it filed for bankruptcy in 2008 – the largest in US
history). Around that time, commercial banks in India were in the process of
implementing BASEL-II norms which were completed by March, 2009. With the
advent of Information Technology, the retail industry boom and modernisation of
communication and data transfer, there have been rapid changes in the way
people and corporates do banking. The most recent development in the banking
business was in 2016 when RBI approved ten entities to set up small finance
banks.

Reserve Bank of India is the
regulatory body of Indian banking. With the adoption of BASEL norms, the
functioning of Indian banks is more standardised and in line with international
practices.

PRESENT SCENARIO

There have been various business strategies
in corporate lending followed by bankers. Banks with large balance sheets have
shown an appetite for taking large exposures and have been also daring to play
long term. On the other hand, Non-Banking Financial Corporations (NBFCs) have
exercised quick entry and timely exit compromising on collateral covers but
snatching from banks the opportunity of making good profit margins. Whatever
the form of these loans, all of these are asset-backed financing models.

By and large, all public sector
banks in India are disbursing loans (long–term, short-term loans, working
capital loans / cash credits) on the basis of assets as security. For term
loans, the primary security are assets like property, plant, equipment (fixed
assets) owned by the company. For short-term loans and working capital loans,
normally stock and debtors (current assets) are the primary security. The
liquidation value of an asset is the primary focus and projected cash flows are
the secondary focus. Cash flows are part of project proposals; however, such
inflows are not linked directly to loan eligibility or repayment / servicing
frequency and mode. This involves a lot of documentation and mortgage of the
asset in the name of the banker till the loan remains outstanding.

Post-disbursal, borrowers submit
periodic performance reports and provisional financials to the bankers as per
agreed terms. This information is not real-time information and in many cases
there are delays in submission of these documents. Banks lack the advanced
analytical tools and bandwidth to assess these reports regularly on a real-time
basis. Non-performance of an asset, i.e., borrower account, gets noticed quite
late when risk exposure is already very high. Increase in non-performing assets
is worrisome not only for the banker but for the economy at large as public
funds are at stake.

One may find that the practice of
asset-based lending has not helped us in timely identification of likely
non-performing credit and immediate reconstruction to put them back on track. A
question therefore arises whether it is time to go for alternate methods of
credit appraisal and adopt international best practices in banking in general
and lending in particular.

PROPOSED CHANGE

Assets don’t help companies to
repay loans. Often, the disposal of assets, primarily immovable property, poses
great difficulty in selling. It’s their cash flow that makes a difference. The
need for mitigation of risk is inherent to the banking business – new
technologies, policies and strategies are adopted from time to time for this.
Under the new mechanism, banks would be able to prioritise their fund
deployment programme. The public sector major, State Bank of India (SBI), has
announced that it will shift to the cash flow-based lending model beginning April,
2020. Other PSUs will not lag behind in following suit; some banks are already
doing it for a portion of their products.

Banks in India have traditionally
lent to companies against their assets. Cash flow-based lending is widely
considered to be a more efficient and safe way of mitigating risk as it reduces
discretion on the part of the lender. The new framework for loan sanctions will
apply to large companies as well as small enterprises.

THE MECHANISM

Cash flow-based lending (CFL)
envisages a shift in the bank’s appraisal system from traditional balance
sheet-based funding to a more objective appraisal system of leveraging the cash
flows of the unit. In CFL, loan requirement is based on actual revenue
generation and capacity to repay. Further, the repayment schedule is based on
the timing of the entity’s cash inflows. Company’s cash conversion cycle is
calculated. Based on cash conversion cycle, the ability of the borrower to pay
back the loan is calculated. With better negotiated terms with vendors / creditors,
the cash conversion cycle will shrink; and with increase in credit period to
the customer, the cash conversion cycle will be longer. While 25% of the
working capital gap (the difference between assessed gross working capital
assets minus gross working capital liabilities) is met by the company, banks
fund the remainder. Most of the working capital finance is in the form of cash
credit, a system where companies freely draw (and service interest) within a
certain limit or drawing power fixed by the lender. Drawing power is arrived at
on the basis of inventory volume minus margin therein. Cash flow lending, then,
is essentially lending to repeated asset conversion cycles and payback is
dependent on the firm’s ability to generate (and retain in the business)
sufficient cash over a number of years of profitable operations to make
required interest and principal payments on the loan. The loan amount as well
as mode of repayment is adjusted with cash inflows based on the cash conversion
cycle. Documented cash flows and the credit rating of the borrower will play an
important role.

A system of determining monthly /
quarterly utilisation limits for credit drawings can be fixed. Actual drawings
should be confined to determine limits. Deviations are not allowed and, when
allowed, they are always with approval from higher levels. The quarterly
monitoring system should ensure no diversion of bank credit for purposes other
than the sanctioned purpose.

NATURE
OF CHANGE IN BASIS OF LENDING

India’s government-owned banks
are likely to change the way they lend. Since the 1970s, public sector banks
have given out most working capital loans and short-term loans required for the
day-to-day operations of a business. Public sector banks have a more than 55%
share of the loan market. These loans were disbursed on the basis of the net
current assets of corporate borrowers. This is considered as a flawed system
that is believed to have resulted in over-funding to some and under-funding to
others. A system which does not focus on entity cash inflows as the primary
basis of loan availment and mode of repayment, often results in delayed
repayments, thus adversely affecting the NPA ratio. The outdated practice may
soon change with the country’s largest lender State Bank of India proposing a
transition from an ‘asset-based lending’ model to ‘cash flow-based lending’, a
mechanism that, among other things, may reduce diversion of funds by borrowers
and enable banks to assess the ability of borrowers to service loans on time.
The shift will require borrowing entities to share their cash flow statements
more frequently with banks.

NATURE OF LOAN PORTFOLIOS

Except for
some seasonal industries such as sugar, public sector banks arrive at a
company’s working capital requirements by considering the difference between
the borrower’s current assets (receivables, raw material stock, finished goods)
and current liabilities (payables like loan interest, taxes, payment to vendors
and workers). While 25% of the working capital gap (the difference between
assessed gross working capital assets minus gross working capital liabilities)
is met by the company, banks fund the remainder, although in many cases they
end up funding more. Most of the working capital finance is in the form of cash
credit, a system where companies freely draw (and service interest) within a
certain limit or drawing power fixed by the lender. Such asset-based lending
ignores the manipulation of the actual value of the assets pledged.

In a country like India a major
portion of the short-term loan portfolios of PSU banks consists of Cash Credit
(CC) accounts. As mentioned above, these loans are disbursed on the basis of
current assets as primary security. These assets themselves are not cash but
there is always conversion time in which these assets will generate cash. On a
broader basis, there would be the cash conversion cycle of every company. These
types of loans are most suited for cash flow-based funding. This is further
suited for MSMEs (Medium, Small and Micro Enterprises). Cash flow-based lending
envisages a shift in the banks’ credit appraisal mechanism and monitoring
system from the traditional balance sheet-based funding to a more objective
appraisal system. In CFL, loan requirement is based on actual revenue
generation and capacity to repay. Furthermore, the repayment schedule is based
on the timing of the MSME’s cash inflows. The advantages of CFL are that the
loan amount and repayment are based on the MSME’s actual cash generation,
reduction in credit risk, reduced monitoring costs for banks, reduction in
turnaround time and ability to serve entities that don’t have adequate
collaterals.

CHANGE IN ASSESSMENT OF BORROWER
BUSINESS

The primary focus in assessment
of business will no longer be the asset base of the balance sheet. The primary
focus will be cash inflows and the cash conversion cycle. Assets will be only
secondary support. Proven past cash flow generation data and credit ratings
will play an important role. Various databases and information available on the
cloud platform will be considered for data analysis. TransUnion CIBIL data will
by and large be considered a reliable source. Nowadays this data is available
at one’s fingertips, thanks to linking of the data base of PAN, Udyog Aadhaar,
Credit Cards. This data is more reliable and available independently for
verification.

IMPACT

Banking disbursement is expected
to rise. As asset backing is no more a primary criterion, companies not having
a large fixed capital base or real estate but having past record of operations
and margins can now avail cash flow-based loans. Various Startups which are in
the category of service sector will be benefited as these cash flow-based
funding loans will be available to these units, thereby increasing the size of
the disbursement portfolios of banks and financial institutions.

IMPACT – On NPA and bank balance
sheet

As mentioned earlier, due to lack
of expertise and bandwidth to assess various financial data real time, the
monitoring was not very effective. Since there was no direct linking of the
timing of cash inflows, the cash conversion cycle and repayment mode and
frequency, there used to be delays and at times diversion of funds, too. With
the shift to cash flow-based funding, these drawbacks will no more result in
NPAs growing without any control as drawings can be stopped when cash flows are
affected. The framework is already available for analysis of data. Databanks
are ready with authenticated data linked to the borrower and access to such
information is available to bankers. Loan amount and repayment frequency when
tied up with cash inflow working and timing, loan disbursal will be more
scientific and will cover the cyclical nature of business. All these will
facilitate timely servicing of loans, thereby improving overall NPA ratio.

IMPACT – On borrowing cost

Since the primary security is
future cash flows based on past records and credit ratings, there is no
tangible security in many cases. The cost of borrowing will tend to be higher
than asset-backed lending. With favourable performance and consistency in
repayment, this cost will also tend to ease out for standard portfolios.

IMPACT – On sectors

Service-oriented businesses with
minimum fixed or tangible capital with proven business model Startups – which
do not have any past record but are in a tie-up with payment gateways for
capturing sales inflows which can be reliably assessed for funding.

Financial Technology Companies
which provide various financial solutions to traders and service providers for
capturing the data real time and for producing various complex reports needed
for assessment will be benefited and the impact will be positive.

INTERNATIONAL PRACTICE

Cash flow-based financing may be
a recent development in India; however, all over the world this is a settled
method of financing, specially to small and medium enterprises, or to
organisations which do not have collateral but have a strong margin business
model, or organisations which do not have past track records and hence
appraisal risks are high; in such cases also, cash flow-based funding is in
vogue.

Key Features:

Lending to finance an entity’s
permanent (long-term) needs, seasonal needs;

Usually medium-term, with loan
terms of up to seven or eight years in most cases;

Covenants in the loan agreement
are often included as a ‘trigger’ to signal to the lender a deteriorating
situation so that corrective action may be taken.

While there are pronounced
advantages in CFL over asset-based lending, the emphasis is on the process of
the lending method. This presupposes a dedicated and purpose-oriented
policy-making personnel equally supported by an alert team of front-end staff.

CONCLUSION

From the foregoing paragraphs one
may conclude that the rapid growth of the Indian economy needs to be
continuously supported by an efficient system of banking dedicated to lend with
care and identify the potential risk much in advance; and also to mitigate the
risk by suitably hedging with a cash flow-based lending in place of asset-based
lending with all its limitations.