It is reported that Prime Minister Narendra Modi has exhorted banks to support start-ups, in a bid to channelise the returns from this fast growing segment into India’s economy. While addressing the chief executives of banks, he said banks, which are flush with liquidity, should now shift focus from their balance sheets towards ‘building the country’s wealth sheet’.
The proposal to finance start-ups out of deposits mobilised by commercial banks is a dangerous one. There is no doubt that start-ups are good and required for the economic growth of the country, but financing them out of banks’ deposits is an entirely different proposition.
Commercial banks are quite different from investment banks. Commercial banks solicit deposits from public which are generally for shorter tenure and lend the same predominantly for working capital finance and other short term and medium term requirements. Investment banks may finance share capital of companies. In India, we have development banks for long-term finance, and commercial banks for short- and medium-term finance.
In 2020, scheduled commercial banks had deposits with the following maturities: maturing up to one year, 40.9 per cent; over one year and up to three years, 24.8 per cent; over three years and up to five years, 9.5 per cent; and over five years and up to 10 years, 24.7 per cent.
Banks do not take deposits beyond 10 years. Hence, a major chunk of commercial banks’ deposits, that is 75 per cent, is repayable within a five-year period. It is fundamental in financial intermediation that long-term financing should not be done with short-term resources. This may lead to disastrous consequences when there is insufficient accumulation of deposits or any slackness in recovery of loans advanced.
It was imprudent to close development financial institutions like Industrial Credit and Investment Corporation of India and Industrial Development Bank of India, which were operating for decades for long term finance of industries. This has led to long term financing by commercial banks, resulting in huge NPAs (non-performing assets) for banks and tremendous pressure on them to match their assets and liabilities.
How successful have start-ups been in India? In the past few years, India has been a nurturing ground for numerous start-ups which, however, are merely clones of Western ideas. The lack of technical innovation in India has led to venture capitalists restricting funding, resulting in the slow decay of entrepreneurship in India.
A report by IBM Institute for Business Value and Oxford Economics found that 90 per cent Indian start-ups fail within the first five years — lack of innovation being the main reason. India is struggling to become the third-largest start-up ecosystem in the world. More and more start-ups are shutting down, and this is leading towards more unemployment.
When such is the reality on the ground, it will not be feasible for commercial banks to finance such start-ups.
Out of deposits mobilised, commercials banks keep as Cash Reserve Ratio, four per cent. They invest a minimum of 18 per cent under Statutory Liquidity Ratio. This leaves the banks with 78 per cent of deposits for lending. But they have a target of 40 per cent for priority sector lending. In other words, this will be around 52 per cent of the deposits.
The banks are generally left with 26 per cent of their deposits for other lending like personal loans, etc. Making banks finance start-ups out of this 26 per cent will be a big challenge.
The way out
No doubt start-ups should be encouraged. But the way to finance them can be through development banks. Alternatively, mutual funds can be encouraged to float separate schemes for financing such ventures and investors with adequate risk appetite can participate in such schemes.
As start-ups come under ‘ high risk, high return’ category, only investors with risk-bearing capacity should be encouraged to invest in such schemes. Suitable lock-in period and huge tax incentives may be required for such mutual fund schemes.
Commercial bank customers come under ‘low risk, low return’ category and their funds should never be invested in high-risk ventures.
The writer is a retired banker