CHAPTER II The Credit Guarantee Mechanism and its status in India 2.1 Credit Guarantee Scheme Globally, Credit Guarantee Schemes (CGS) are seen as important instruments to facilitate achievement of national economic goals as they enable entrepreneurs to gain access to finance for venture creation and development (Samujh, Twiname and Reutemann, 2012). Boocock and Shariff (2005, p.428) define CGS as schemes where financial institutions are encouraged to make loans available to smaller enterprises, on the understanding that a government and quasi-government body will reimburse a percentage of the loan, should the firm default. Thus, the Credit Guarantee Scheme is an important instrument of state policy to address the issue of access to Finance by SMEs. Usually, the SMEs have limited access or their access to credit from the Banking system is handicapped because of their inability for collateralizing the proposed loan assistance. The focus of the Bankers on collaterals is accentuated by the facts that the SMEs have little or no credit history, lack of structured financial statements as expected by the Bankers and the information asymmetry that exists between the SMEs and the potential lender. Thus, the lenders attribute a high risk of default to the SME borrower. This explains the Bankers insistence on adequate collateral to hedge against a probable risk of default. 2.2 Economic theorization Access to Finance, it is widely believed is the most important challenge faced by the MSMEs world-wide. However, there are several other handicaps befaced by the sector 32
which include market linkages, access to credible, relevant and appropriate information, unfriendly legal framework and regulatory environment, lack of skill-sets and low managerial band-width and more over, lack of entrepreneurial skills. The MSMEs are perceived to be risky and this perception often affects the credit flow to this segment. Moreover, the small size of the loans makes these transactions not so cost effective. Furthermore, most importantly, net of write offs and provisions, the return from SME loans are supposedly very low. MSMEs being emerging businesses face the usual uncertainty and the high mortality rates does not enthuse the formal financial system. Thus, the Lending institutions endeavor to incentivize borrowers for repayments and try to in-build enforcement actions for the events of default. Thus, they often resort to insistence on collateral security. Broadly, it can be summarized that the following are reasons for lack of adequate institutional finance to MSMEs. 1. Small businesses generally have higher mortality rates in comparison to larger businesses and this makes them more vulnerable to economic and market changes. 2. Because of lack of past track record or credit history, the small businesses are at a disadvantage vis-à-vis established firms. 3. The ticket size being small, small business finance is perceived to be costly, thus may be non-remunerative for the banks. 4. Lack or absence of reliable information to base credit decisions for the banks. 5. Lack of back up assets to be provided to the banks for securing the assistance to the small businesses. 33
6. Often, contract enforcement difficulties as also associated costs, especially for a small business in comparison to returns is a discouraging factor for enhancing credit flow to the sector. Stiglitz and Weiss (1981) in their seminal work Credit Rationing in markets with imperfect information have concluded that there are no competitive forces in action to increase the price of the commodity (Bank Loan) in order to bring an equilibrium in demand and supply. They further add that the pricing of a loan may not often work as a screening mechanism for selecting credit-worthy SMEs as information asymmetries may lead to adverse selection. As higher interest rates attract high risk borrowers, adverse selection effect is introduced as good quality borrowers may find the interest rate unattractive. Such high risk borrowers might take up high risk projects with an expectation of higher return to serve the high cost debt. Thus, moral hazard effect comes in to play. Hence, because of information asymmetry, the bankers do not prefer to increase the pricing of the loan, rather they opt for Credit rationing. The collateral security attempts to bridge the gap between a lender and a borrower as the borrower, who has an informational advantage about the proposed business, by offering collateral security, reinforces the belief in the minds of his Bankers about the viability aspect of the business. Thus, collateral acts as a tool to overcome the issue of information asymmetry and consequent credit rationing issue. However, if an SME is not in a position to offer collateral or the country s legal system is not adequate to protect lenders rights, the access to finance by SMEs would continue to remain restricted. Zecchini, Ventura (2009) mention that about 83% of bank loans in Italy are backed by guarantees that mostly take 34
the form of real asset pledge (65 per cent of Bank credit). Thus, there exists a market imperfection due to lack of information that affects the availability of credit. Hugh Dalton, the famous British Economist in his seminal work Basic doctrine of Public Finance had propounded that Government intervenes when there exists a market imperfection. In the event of the existence of market imperfection in SME finance, this market imperfection also leads to an intervention from the state either directly or through state sponsored institutions. The system of Credit Guarantee is one such tool to tide over this market imperfection in terms of access to credit by SMEs. Evans & Jovanovic (1989) opine that the belief that capital markets do not provide adequate funds for new business is the rationale for public loan assistance programs such as credit guarantee to small business. The Credit Guarantee is a widely used response, mostly by State to this market failure. Through this mechanism, a portion of the loan is insured against probable default. Thus, the mechanism reduces the risk of the lender and encourages lending to viable business proposals. Beck, Demirguc-Kunt and Martinez Peria (2008) have reported that the lenders consider the CGS as the most effective government intervention for SME lending, ahead of directed credit and interest rate or regulatory subsidies. Kang, Heshmati and Choi (2008) conclude that among many direct and indirect support measures, the Credit Guarantee system is seen as one of the most important instruments to achieve national economic policy goals. The prime objective of CGSs is to encourage lending institutions especially banks, to extend loans to small enterprises with viable and feasible projects. However, they are 35
unable to provide adequate collateral security or they do not have a past record of financial transactions to support their creditworthiness. Green (2003) had estimated that over 2250 guarantee schemes existed in over 100 countries world-wide. With few exceptions, Credit Guarantee Institutions exist in almost all countries. Uesugi, Sakai & Yamashiro (2010) have traced that during the 2008 financial crisis, policies to create or extend Credit Guarantee Scheme to improve access to liquidity by SMEs were developed in 19 of the 23 countries within the Organization of Economic Co-operation and Development (OECD). The following graph depicts the share of outstanding guarantees portfolio as a percentage of GDP in certain countries. As can be observed, it is highest in countries like Japan, Korea, Chinese Taipei etc. Traditionally, these countries are known to have a very strong and resilient SME sector. Graph 2.1 Volume of outstanding Guarantee Portfolio (2011) as a percentage of GDP Source: OECD, 2013 36
As can be seen from the above graph, countries like Japan, Korea, Taiwan, Italy etc have a significant share of guarantees in the GDP. These countries are known to be having a very strong and resilient MSME sector. These countries are also known for innovations in credit guarantee mechanisms for their MSME sector. This graph possibly throws some insight in to the role of credit guarantee in development of their respective SME sector. 2.3 Credit Guarantee in India India witnessed the advent of formal Credit Guarantee system in the form of Export Credit Guarantee Corporation (ECGC). Set up in 1957, the ECGC provided credit insurance cover for export credit and also trade related services to the exporters. It started under the name and style of Exports Risk Insurance Corporation and operates as a Government Company under the Ministry of Commerce and Industry. It assumed the name of ECGC from 1964. Its principal functions are as under: Provide guarantee cover to Banks and Financial Institutions to encourage them to provide better credit facilities to the exporters, Offer a range of export credit risk insurance products to exporters against possible losses, Extending overseas investment insurance cover to Indian Companies for investment in international joint ventures, either in the form of debt or equity. From the onset of the year 1962, the Deposit Insurance Corporation (DIC) was set up under an Act of Parliament as a wholly owned subsidiary of Reserve Bank of India (RBI). The purpose was to guarantee the deposits of public with both private and public 37
sector Banks. During 1971, the RBI set up the Credit Guarantee Corporation of India (CGCI). While DIC envisaged to protect the interest of depositors, ensure financial stability by instilling confidence of depositors in the banking system thereby mobilizing more deposits, the CGCI was primarily aimed to expand the credit reach to hitherto neglected sectors. During the year 1978, DIC and CGCI were merged to form the Deposit Insurance and Credit Guarantee Corporation (DICGC). The focus of DICGC gradually shifted to Credit guarantee. However, after the initiation of the process of liberalization of Indian Economy followed by financial sector reforms, the Credit Guarantee function was relegated to backburner and DICGC functioned with its thrust back on Deposit Insurance services. 2.4 Credit Guarantee Trust Fund for Micro & Small Enterprises (CGTMSE) With the increasing globalization of Indian Economy and with increasing realization of potential of Indian MSMEs to be a part of global value chain, the issue of access to finance by MSMEs received increased policy focus. Across the globe, several nations have adopted partial Credit Guarantee schemes as a central part of their strategies to alleviate the financing constraints of SMEs (Das, P. K., 2013). In India, the Government of India through its Ministry of Micro, Small and Medium Enterprises and the Small Industries Development Bank of India (SIDBI) have come together to set up the Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE). Set up on July 27, 2000, the Trust focuses on Micro & Small Enterprises only. The envisaged corpus of the Trust was INR 2,500 Crore with contribution from Government of India and SIDBI in a ratio of 4:1. 38
The principal objective of CGTMSE is that the lender should give primacy to viability of projects and secure the credit facility based on their strengths and on the primary security of the assets financed. The scheme also endeavors that the lender availing the guarantee facility should provide composite credit to the borrowers. In other words, the borrowers should be in a position to obtain both term loan and working capital facilities from a single source. The Credit Guarantee scheme (CGS) seeks to reassure the Lending institutions that, in the event of any future default by an MSE unit, which availed collateral free credit facilities, the Trust would compensate them for the loss incurred by them up to a maximum of 85 per cent of the sanctioned and disbursed credit facility. The Scheme covers collateral free credit facility (term loan and / or working capital) extended by eligible lending institutions to new and existing micro and small enterprises up to Rs. 100 lakh per borrowing unit. The guarantee cover provided is up to 75% of the credit facility up to Rs. 50 lakh with an incremental guarantee of 50% of the credit facility above Rs. 50 lakh and up to Rs. 100 lakh (85% for loans up to Rs. 5 lakh provided to micro enterprises, 80% for MSEs owned/operated by women and all loans to NER). 2.4.1 Objectives of the Scheme: The prime objective of the scheme is to ensure better flow of credit to Micro and Small Enterprises by minimizing the risk perception of banks/ financial institutions in lending up to Rs. 100 lakh without collateral / third party guarantees. Other objectives are: 39
Shift from collateral to merit based lending Act as catalyst of entrepreneurship promotion Facilitate institutional credit flow to MSE sector Address growth constraints of MSE sector Enable financial inclusion/ employment generation Revive confidence in credit guarantee mechanism 2.4.2 Salient Features: Micro & Small Enterprises as per MSMED Act eligible Both Manufacturing and Service sectors covered. Credit Facility up to Rs.100 lakh covered All fund/non-fund based facility covered Maximum Cover of up to 85% of credit facility All credit facility must be extended without any collateral security However, Credit for retail trade, educational/training institutions and SHGs not eligible for coverage. 2.5 The expanding outreach of CGTMSE Over the years, the CGS has been expanding its coverage and as on March 31, 2013, it had 118 Member Lending Institutions. (MLIs). The growth in the number of MLIs over the years is depicted in the Graph 2.2. 40
Graph 2.2 The composition of the MLIs includes commercial Banks included in the second schedule of the RBI Act of 1934 which covers the Regional Rural Banks as well. The State Finance Corporations (SFCs) with certain criteria (positive Net-worth, CRAR of 9 per cent etc) are also Member Lending Institutions. Besides, the North Eastern Finance & Development Corporation (NEDFi), National Small Industries Corporation and Small Industries Development Bank of India (SIDBI) are also Member Lending Institutions. 2.6 The expanding coverage by CGTMSE With expanding MLIs, the coverage of the CGTMSE in terms of both numbers and amount are also increasing. The growth has been depicted in Graphs 2.3 & 2.4. 41
Graph 2.3 Graph 2.4 As can be seen, in terms of both numbers and amount, the Guarantee scheme has been witnessing a phenomenal growth. The growth has picked up momentum after 2009. 42
During June 2009, CGTMSE and the country s largest lender, the State Bank of India (SBI) had entered into a pact under a new product launched by CGTMSE viz. Portfolio Guarantee Scheme. Under the scheme, CGTMSE agreed to extend guarantee to SBI for its entire portfolio of all loans to Micro & Small Enterprises which were below INR 100 lakh and were without collateral security. As a result, State Bank of India, the largest Indian Bank has a lion s share in the guarantees approved by the CGTMSE. The top 12 MLI wise guarantees approved is given in Table 2.1. Table 2.1 Top 12 MLIs by amount of approved guarantees as of March 31, 2013 (cumulative) Sr. Member Lending No. Institutions 1 State Bank of India 2 Bank of India 3 4 No of guarantees Guaranteed amount [INR Lakh] 224313 966703 116840 719209 Punjab National Bank 99201 470544 Indian Overseas Bank 70767 317031 5 Bank of Baroda 6 Canara Bank 7 34218 281774 72685 247735 Central Bank of India 34567 225923 8 Allahabad Bank 9 Syndicate Bank 41453 164126 29830 153606 10 Oriental Bank of 13226 132628 Commerce 11 United Bank of India 30767 129845 12 13 Union Bank of India 34336 126853 OTHERS 269893 1259309 Average loan size [INR Lakh] 4.31 6.16 4.74 4.47 8.23 3.40 6.53 3.45 5.15 10.02 4.22 3.69 4.66 43
As can be seen from the above table, the out of 118 MLIs, the top 10 per cent i.e 12 MLIs have contributed over 75 per cent (75.76%) of cumulative guarantee amount. Even in terms of number, these 12 MLIs account for about 75 per cent (74.8%) of cumulative guarantees issued. The Compound Annual Growth Rate (CAGR) of the guarantee amount is over 102 per cent over the 13 year period. In terms of number, the scheme has recorded a CAGR of over 72 per cent. 2.7 The Guarantee mechanism A schematic representation of the CGTMSE guarantee scheme is presented below at figure 2.1. Figure 2.1 : Guarantee Coverage Registration & Payment of guarantee fee Bank / Financial Institution Credit to Micro & Small Enterprise Pays Guarantee fee for coverage On-line registration of the Loan Account for Guarantee cover over B2B portal Accepts Coverage and allots unique number CGTMSE Claim settlement Invocation of guarantee Bank / Financial Institution Account turns NPA Pays share of recovery after Settlement Invokes Guarantee after Lock-in period Eligible claims are paid 75% within 30 days CGTMSE 44
With the above simplified B2B online platform, the CGTMSE has endeavored to make the process of guarantee approvals and guarantee invocation as simple as possible. The Reserve Bank of India had set up a working group during 2010 to study the functioning of the Guarantee mechanism. There was broad consensus that the Trust has been able to meet its objectives though it also made several suggestions to further improve the flow of credit to the Micro & Small Enterprises sector. The Reserve Bank of India, as the banking regulator in the country has prescribed zero risk weight to the exposure of Banks to MSE sector covered under CGTMSE guarantee. The outstanding Guarantees under CGTMSE have been increasing in tandem with outstanding MSME credit over the years. The same has been presented in Table 2.2. Table 2.2 Outstanding MSME credit vs. Guarantee outstanding O/S MSME Credit (Rs. lakh crore) O/S Guarantees (Rs.cr.) 2001 65281 5.55 2002 72627 27.71 2003 71336 59.38 2004 79989 110.26 2005 93608 307.04 2006 116508 425 2007 154063 648.73 2008 213539 950.66 2009 256128 1972.92 2010 362291 6431.46 2011 478527 11979.7 2012 527684 13278.74 2013 684797 15753.72 Source: RBI Trend & progress of Banking in India, CGTMSE 2.8 The Motivation and objective for the current Research The MSME sector in India is exhibiting tremendous potential in terms of its contribution to exports and employment. The sector has the capability of contributing greatly to the 45
national mission of inclusive growth through its adaptability, tenacity, its job creation potential and equitable growth opportunities. With over 46 million MSME units, along with opportunities, the sector also throws up several growth challenges. Access to finance has been categorized as one of the most important challenges faced by the sector. With an objective to facilitate access to finance by MSME units by addressing the issue of collateral security, the welfare states across the globe resort to several policy interventions. The Credit Guarantee mechanism is by far considered as one of the most important interventions by the state. The Credit Guarantee replaces the requirement of Collateral security by Banks. The reason why Banks insist on Collateral Security is to hedge against future default scenarios. The Banks primarily consider a future event of default because of lack of understanding of the project which is attributed to the presence of information asymmetry. There are several works which have attempted to determine the efficacy of Credit Guarantees across the globe. However, Beck et al, (2010) Opine that there is a dearth of analysis to systematically inform the process of design, implementation and evaluation of these (CGS) instruments. It is very important to ascertain the impact of this very important public policy. In Indian context, there is a dearth of available literature on the efficacy of Credit Guarantee scheme. As it is very interesting to actually examine the impact of this intervention on MSE segment, the current work tries to fill the void in the available literature. 46
2.9 The efficacy measurement dimension of Guarantee Schemes World over, the Credit Guarantee Schemes efficacy is measured by its incrementality effect. The incrementality encompasses the additionality effects, both financial additionality and the economic additionality. Gudger (1998) defines additionality as a small investment in a guarantee institution s capital and/or ongoing administrative support to guarantee institutions can produce a significantly larger volume of lending to a credit constrained sector than would have been achieved without such guarantees. The current work has made an attempt to measure this additionality in Indian context especially the economic effects of the intervention with special reference to the east Indian state of Odisha. The detailed objective of the study has been discussed in subsequent chapter(s). 47