The Hindu Business Line : A new turn in bank lending

LAST WEEK ENDED on the news, among others, that banks were undergoing a temporary liquidity pressure, with call rates shooting up to 7 per cent by November 11, up from a steady 5.5 per cent. Bankers say the liquidity is because of heavy borrowings by oil companies, corporates paying bonuses and salaries, and mutual funds facing redemption pressures. According to some dealers, more than Rs 6,000 crore cash withdrawals took place during the festive season, with attendant pressures on the overnight inter-bank rates. On a surface view, temporary liquidity pressures on the banking system and cresting call rates may spell little by way of a crisis in the financial system simply because the RBI steps in to adjust those fluctuating pressures through the Liquidity Adjustment Facility. But the central bank may find it more difficult to cope with the problem behind last week's liquidity pressures.

With the opening up of the market and competition in the financial system banks have, of late, been disbursing far more credit to the commercial sector than they did in the early 1990s. Net bank credit to the government, for instance, has been steadily declining since 2003-04, while net bank credit to the commercial sector has been rising year on year, albeit with fluctuations. Admittedly, the rise is over a low base since, in the last decade, banks went through a conservative spell, parking their funds in government securities.

In the first flush of balance-sheet reform, banks played it safe to cut down on defaulters. The irony is that in this second phase of reform, when banks are boasting healthy records, they are still playing the "risk-averse" game. This time they are lending, in the main, to large companies at rates below the prime lending rate (PLR). In the early phase, banks made a distinction between the government and the commercial sector, while in this phase, they seem to be drawing lines within the commercial sector. The instrument of this inequity is the PLR.

Banks lend to large companies at rates below the benchmark PLR, a practice that has become so prevalent as to draw the attention of the central bank. Sub-PLR lending implies an under-pricing of credit risks to large companies and an over-pricing of risks to smaller ones, crowding out the latter. Why are banks lending to high-value customers below the cost of funds? The obvious reason would appear to be the safety of funds. Default risk, at least on paper, appears to be lower, especially since small and medium enterprises (SMEs) are not yet rated. The good news is that Crisil has launched an SME credit rating system that should make banks look at such entities seriously; in fact, soon, they may have little choice but to do so. Large companies have multiple choices to source funds from and, increasingly, banks will be cutting margins even finer to win their business. Many banks will eventually be forced to look elsewhere to park their funds. Markets, and not diktats, it seems, will come to the aid of the small sector.

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