New Lending Approach – Cash is king

Abstract:
In traditional banking approach, lending is backed by security. When a business owner applies for loan, one of the first question which he/she encounters is “what is the security which you can offer of the loan”.

However, it is observed security based lending approach has several limitations such as marketability of the security may be less, too much attention on security may lead to wrong credit decision, repayment capacity is not assessed as it cannot support the repayment of credit facility.

The limitation in “security obsessed lending” approach is one of the reason for mounting NPA across banking industry. In order to overcome the limitation of this method, banks/FIs have started adopting “Cash based lending” .
In cash flow based loan, the documented cash flow plays a key role in determining the loan limit. At the end of the day, cash is the only factor that can repay a loan. Hence, it is a more practical assessment approach for lending.

Introduction:
As per Section 5(b) of the Banking Regulation Act, 1949, “banking” means acceptance, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawable by cheque, draft, order or otherwise.

Thus, from the above definition we understand that “banks” were established for two primary reasons – acceptance of deposit from public and lending & investing the deployable fund collected from public.

It is the responsibility of the bank to invest/lend the funds collected from the public in profitable deal so that the public who have deployed their fund in the bank do not incur any loss. Moreover, bank enter into a contractual relation with the public that it will repay the amount deposited by the public on their demand or after certain specified time as per the terms & conditions of the contract. Thus, even if the loan or investment leads to loss for the bank, it must repay the fund to the public. In other word, loss due to wrong lending or investment will be borne by the bank.

It is observed that banks usually invests in bonds, T-Bills issued by Government bodies, hence, the risk of loss due to investment decision is almost negligible. The serious risk which the bank encounters is “Credit risk” i.e. the risk of loss which may arise due to the lending activity of the bank.

Measures to Mitigate Credit Risk:
Banks are integral part of a country’s economy. It is essential that the bank must follow certain rules/regulations & guidelines so that they don’t get exposed to unmanageable risks, which may in turn lead to their premature death.

In India, the regulatory body Reserve Bank of India (RBI) issues circulars, master directions advising banks to follow certain standardised guidelines. Apart from this, bank also frames its own policies and procedures within the framework of guidelines issued by Reserve Bank of India.

Despite these stringent monitoring measures it is observed that level of NPA (Non Performing Assets) has increased rapidly in the entire banking industry.

As per the RBI’s Financial Stability Report of June 2018, scheduled commercial bank’s Gross Non Performing Asset (GNPA) ratio rose from 10.2% in September 2016 to 11.60% in March 2018.

Although there are several Micro & Macro economic factors contributing to increase in NPA level but it cannot also be denied that there are shortcomings in the assessment methods used by banks while taking accredit decision.

Credit Assessment:
It is the process of estimating the risk involved in the credit decisions. “Risk cannot be eliminated but it can be mitigated”. Traditionally, banks consider 5 C’s for any credit decision – Character (Integrity, commitment, sincerity of the promoter/borrower), Capacity (ability to execute the purpose for which the loan is requested), Capital (promoter/ borrower ability to contribute own funds), Condition (ability to comply with the Terms & Conditions of sanction which will be advised by the bank for the loan facility) and Collateral (ability to offer additional security as a safeguard for mitigating loss).

The above mentioned parameters are being judged using tools like Financial Statements, Income Tax Return, Wealth Tax Return, Credit Information Report etc. However, these tools have not been able to prevent the occurrences of loan default.

There are certain limitations in the traditional approach of credit assessment which are as follows:
Security obsessed lending: Collateral is one of the parameter for credit decision but unfortunately it has become “most important parameters” for credit decision. Over a period of time, it is observed that with the increase in complexity in business models, bank has identified an easy way of sanctioning loan against certain percentage of collateral offered.

Suppose a borrower is willing to offer collateral of Rs.10,000/- then bank will be ready for sanction of Rs.6000 (i.e. 60% of security value). The major shortcoming in this approach is that the ability to repay the loan by the borrower was not ascertained and over a period of time the marketability of the security also gets reduced. As a result, the loans sanctioned based on “security obsessed approach” have turned NPA over a period of time. Sub -prime crisis happened due to security obsessed lending approach.

Financial statement & records: The assessment of credit limit is done based on audited financial statements and estimated & projected financial figures submitted by the borrowers, Income tax return etc. Too much dependency on such statements also leads to a myopic credit decision. Recently several instances of fraud are hitting headlines of newspapers at a frequent interval, several questions are being raised by “diktats” regarding the sanctity of the audited financial statements and other data furnished by corporate borrowers based on which the credit decision is taken by the banks.

Moreover, these records & statements acts as documentary evidence of the past performance of the loan applicant but it do not guarantee that future performance will be in line with the past trend. Another major challenge in the “Paper obsessed lending” approach is that many small – unorganised & unbanked segment are excluded from the formal sources of credit as they do not have the ability and required skill to prepare and submit the financial documents for loan.

Changing Business scenario: With the advent of technology, the business models are also changing rapidly. The young entrepreneurs are leveraging digital dividends and minting money through app based business platform. As a result the traditional credit assessment methods like MPBF methods are slowly becoming obsolete.

The “one size fits all” approach should be avoided and banks must explore alternate methods of assessment based on the emerging new age business model.

Alternate Lending Model:
If we analyse the instances of corporate frauds which has happened in the recent past be it Satyam, Sahara or Kingfisher Airlines, the frauds were perpetrated by “window dressing the financial statements” and “doctoring the key financial parameters of the company’.

In this “situation of crisis” how bank’s can take a better credit decision? What strategy must the banks adopt while lending? The answer to this question is “Focus on Cash”.

We all know that it is the “Cash” which is the going to repay the loan, so banks must focus on the source of loan repayment i.e. “Cash”.

The profit & loss account statement is based on accrual method of lending i.e. it takes into account the transaction which has occurred during a particular period but it do not provides information as to if the cash is actually received from the transaction or not. Company reports a sales of Rs. 1 Crs in its Profit & loss account as on 31st march 2018. On 1st April 2018, the firm showed sales return of Rs. 90 laces (out of Rs.1 cars already reported) and out of remaining Rs. 10 lacs (Rs.1Cr – Rs.90.00 lacs), it is not clear from the profit & loss account as to what amount of cash is actually received by the firm.

To overcome these challenges, banks are focussing more on “Cash flow statement” and cash-based lending techniques.
In the cash flow lending method, the net cash flow generated from the business is the determining factor for the loan amount, loan tenure, periodicity of repayment. This method is also considered as an appropriate strategy for lending to MSMEs given that non-availability of collateral security by these borrowers.

Some of the instances where cash flow have been the key parameter of lending are lease rental discounting, warehouse finance, supply chain finance, value chain finance etc. These methods are suitable for large corporate lenders. On the other hand, for small unorganised borrowers also, the new age fintech companies have devised cash lending products like Merchant cash advance, loan against card swipes etc.

In the cash-based method of assessment the major role of lender will be to ascertain the following:
Source of cash flow: Cash flow from the core business operation of the borrower should be the major source of loan repayment as it will ensure stability of the business. It may happen that a firm, say a manufacturer of jewellery makes a windfall profit in one particular year out of trading of bullion. Though, the overall cash flow of the firm will be high in that particular year but that “stability of the cash flow” is not ensured. It may happen that in the subsequent year the cash flow from bullion trading becomes negligible. Thus, bank must take into account the source of cash flow for assessment of the credit limit.

Periodicity of cash flow: Suppose a bank wants to lend to a tea broker, generally during the winter season, tea plucking activity remains suspended and no auction of tea takes place during the period and therefore cash flow of the tea broker will be less during the period. Now, if the bank fix a standard EMI for this tea broker for all the months, then the loan account may come under stress because during the winter season as the borrower may not have adequate cash flow to honour the debt obligation. In this scenario, bank must fix a ballooning repayment method i.e. initial EMI must be of higher amount compared to the EMI’s of the later part of the month.

Ring fencing of cash flow: “Ring fencing of cash flow” is the process of capturing the cash flow generated from the business of the borrower so as to reduce the instances of diversion of fund or siphoning of fund. One of the main reasons for growing importance of cash flow method of lending is that the lender can identify the source of cash inflow and also capture its movement, as a result the repayment of loan is ensured. On the other hand, in case of asset based lending, the movement of cash flow is not traced by the lender, the borrower takes undue advantage of the situation and misuses the cash generated out of business which leads the account into NPA.

Common Methods of Cash Based Lending:
Lease Rent discounting: It is a method of lending used for granting term loan facility to corporate clients. It is commonly used in case of commercial real estate projects like Mall financing. The loan is sanctioned against the rent which will be derived from the lease contracts executed between Mall owners & clients. The loan tenure will be fixed based on duration of lease agreement and the rent amount is to be collected in an escrow account maintained with the lender. Thus, in this model, the cash flow of the borrower is captured through escrow account and repayment is made directly out of the rent received.

Warehouse receipts finance: This type of loan is extended to owner of goods, manufacturers against warehouse receipts issued by collateral managers with whom the bank has a tie up. The loan will be liquidated out of sales proceeds of the goods. In this type of lending both the movement of stock and cash flow can be monitored by the lender. The stock which goes out of the warehouse is recorded and sales proceeds generated out of the sale of stock are collected in the account maintained with lender.

Supply chain finance: It is a cash flow solution. In this lending technique buyer purchase the product from the supplier. The supplier then issues invoice to the buyer. The buyer submits the invoice to the bank, which in turn makes payment to the supplier. On due date the buyer makes payment to the bank. This financing model is a win – win situation for all the parties. The supplier gets immediate payment from the bank, the bank is ensured about the transaction that actual trade between the buyer and seller has taken place and on the other hand buyer will get some time (credit period) to make the payment.

Value chain finance: Value chain finance is a method of lending, wherein financial assistance is provided at any of the point or through any point in value chain. In a business cycle there are multiple stakeholders involved at different level. This product facilitates lending to stakeholders at any required point. The cash flow is captured to ensure repayment.

Apart from the above, some popular methods of lending used by new age fin techs are:

Merchant cash advance: In this method, credit limit is sanctioned to small borrowers against the monthly card settlement. Loan is sanctioned even up to 200% of the monthly sales proceeds received in the POS machines, through card payment. The entire procedure takes just 10 minutes. The repayment is also ensured as the
amount collected from POS machine is collected in a particular current account from where the repayment of loan is made.

The growing importance of cash flow based assessment has not only contributed to evolvement of new products but also several ratios for better credit assessments. Some of the ratios are:
Cash flow from operation to sales ratio: This ratio indicates the ability of the firm to generate cash from the sales which is registered. It indicates how much percentage of sales is blocked in the debtors and how is the quality of the debtors. It also helps in lifting the veil of fake sales, if the ratio is less and persistently declining then it may also indicate that the firm is recording fake sales to make the financial statement bankable.

Cash flow from operations to Interest: This ratio is also known as “cash interest coverage ratio”. It indicates ability of the firm to repay interest out of the cash generated from the core business activity. The higher the ratio, the better is the position of the firm. As we have already discussed above, that profit after tax (PAT) is derived from accrual method, it do not indicate the actual cash position of the firm. The true and fair ability of the firm cannot be ascertained from traditional interest coverage ratio.

Cash generation to debt repayment: The ratio is derived (Cash flow from operation+interest on term loan )÷(interest on term loan+installment of term loan). It is a supplement to Debt Service Coverage Ratio (DSCR). Instead of Profit after Tax (PAT), cash flow from operation is used to ascertain the capability to repay the debt obligation. The ratio is more practical in nature as it considers the actual cash flow from operation instead of Profit after tax.

Considering the benefits of “cash based lending” technique, banks have started adopting the method for assessment.

Conclusion:
Controlling of cash flow is need of the hour in order to ensure quality of credit. With a shift to cash flows, lenders can better assess the repayment capacity and liquidity position of the clients. This shift will help in developing new lending products and explore new target market.

It will also benefit small borrowers as they will not be required to offer collateral for availing credit. It can avail loan against the cash flow generated from the business.

Let us accept that – “Revenue is Vanity, Profit is sanity but cash is King”.

Authored By:

R Sumitra
Faculty, Baroda Apex Academy,
Bank of Baroda