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Fueling India’s economy by diversifying access to non-bank funding

Recurring news headlines call attention to recently exposed bank fraud in India. While the fraud is concerning — and an issue that needs to be addressed — the surrounding turmoil is somewhat conflated with the larger problem of non-performing assets (NPAs), or bad loans, accumulated during the boom period of over-lending prior to 2010.

Since the reserve bank triggered its rigorous asset review in 2015, banks are under increasing pressure to address the situation. This resolution includes an automatic system where the larger NPAs must enter a 270-day bankruptcy resolution process. Now, at the end of the first few months of that process, some of these companies are undergoing transitions in ownership and leadership.

The situation is far from resolved, and has lasting implications beyond a 270-day period, implications that may impact India’s banking system, the pace of economic growth, access to lending for smaller companies. There is a bright spot, however, with the expansion of alternative lending and fintech and the growth of private banking.

A shifting balance in the banking system

Seventy percent of these non-performing assets are in public sector banks, accounting for the largest of the NPAs and the largest losses. This ability of public sector banks to continue lending in support of the potential economic growth for India will be jeopardized if more capital is not brought in. A more restrictive lending environment is likely to occur, as evidenced by a reduction in the growth of credit from 13-14 percent to a low of 4-5 percent before bouncing back a bit.

Outside of the NPA and fraud issues, public sector banks have been criticized for their lack of agility and credit evaluation systems with added bureaucratic procedures over commercial bank lending.

Within this climate of uncertainty, private banking is growing. Currently, private banking only accounts for 30 percent of the total share of assets, but lending from this sector is expanding at a rate of 20 percent per year compared to growth of the public sector at only five percent per year. Given the disparate growth rates, private banking is anticipated to reach 50 percent of the market in ten years.

In the meantime, these banking issues, and resulting credit constraints and increased regulatory pressure to control fraud, may slow down India’s rapidly growing economy.

Smaller businesses feel the impact first

Smaller businesses face the most challenges from high interest rates or a lack of access to capital even at the rate that applies to them. According to the World Bank only 13 to 15 percent of SMEs are financed through formal financial institutions in India.

Should regulatory pressure increase, this may further restrict access to credit for small and midsize businesses as banks seek to limit exposure and risk.

Of the SMEs in India with access to traditional sources of funding, much of this financing is backed by the collateral securities provided by the company or promoter. Typically, the amount an SME can borrow is directly linked to the ease and liquidation value of their collateral in case the borrower is unable to repay the loan.

Rapidly growing businesses have funding needs that exceed the value of the underlying securities. These companies may also be constrained by the ability of the promoters to bring in the required collateral securities to fund the company in an adequate and timely fashion. The gap for “growth-friendly” funding has a bright spot for one financial sector: alternative finance.

Growth of alternative finance and supplier finance in India

When traditional banking is constrained, alternatives gain market share. According to the C2FO Working Capital Outlook Survey, 95 percent of Indian suppliers surveyed were open to alternative options for cash flow. Use of digital payments grew an astounding 55 percent in 2016-17. Use of these payment platforms shows promise for building financial history data that can be used in lieu of traditional risk-based underwriting. The alternative finance sector grew, on average, 211 percent per year from 2013-2016.

Another funding alternative that is gaining ground in India is the growth of supplier finance from supply chain finance for larger companies to receivables finance. Early payment platforms such as C2FO are also on the rise. One of the advantages of the C2FO model is that it does not rely on financial intermediaries. Payment is issued directly from a customer to the supplier at an affordable rate of discount that the supplier determines.

A future with multiple sources of revenue that fuel growth

As promising as these alternatives are, they still comprise a relatively small sector of assets in India and must expand rapidly to offset the main part of banking system issues. Maintaining rapid economic growth in India requires a robust financial system that includes both traditional funding and “growth-friendly” funding alternatives.