Collateral based loans- A risky proposition to SMEs in India

Emphasis on the value of collateral security instead of the technical feasibility & economic viability of the project is leading to recklessness and resulting in distress.

Recently I had an interaction with one entrepreneur who has been reeling under distress. He is into manufacturing commodity product which by nature enjoys low margin and is highly vulnerable to the fortune of industry and economy. In other words, the scope for innovations to improve the profitability is extremely remote or nil. Many units in this industry have been going through the distressing time since last few years and demonetisation exercise undertaken in 2016 has just aggravated the problem.

When I started intensely analysing the case, I found that the root cause of failure lies in its origin. There was no due attention for proper appraisal of the project for its economic viability and technical feasibility. The industry is highly competitive and already reeling through distress for many reasons mainly due to weak international market. The industry requires stringer operational strategy for navigating the challenges. Being an SME there exists lesser emphasis on talent acquisition which is vital for sustenance of the business. With all the effort to overcome the challenges, still there are little chances of success unless the company has in place a robust financial management strategy.

When I glanced through the project report prepared initially, I found that the report submitted for securing the loan was just enough to justify the project from the perspective of lending parameters of the Bank. All the assumptions were sounding very aggressive. The assessment of risks was glossed over.

The obvious question is-  How the loan of such an amount was sanctioned? Whether bank was exposed to possible losses if the project fails?

No, the bank was not exposed to risk. Because the bank has taken the collateral security of premium properties owned by the members of the family. Indeed, more than two times the loan is taken.

Collateral security based lending decisions- a new scourge gripping banks and NBFCS

In the true spirit of lending, banker and borrower should jointly work towards assessment of the viability of the project and take a pragmatic view about of repayment of debt so proposed. Securing the intended exposure through collateral security is just an incidental event to help the bank to protect the public money so lent and should not be the major driver to lend.

However, in the recent years, there is a spate of NBFCs and banks rolling out imaginative products on mortgage thanks to SARFAESI Act.  Because SARFEASI Act facilitates quicker resolution of NPAs through enabling provision for selling bad debts to Asset Reconstruction Companies or seeking liquidation of assets without the intervention of court.

Mortgage sustains on the direct relationship between loan amount with the value of the asset and obviously, there is no or lesser emphasis on the viability of project undertaken. This has resulted in lending becoming highly commoditised and sadly spreading faster into SME space, a segment requires delicate handling by the lenders.

Recently I was interacting with a senior functionary of SME development agency. He was complaining that the banks are not keen on lending against stock and book debts for SMEs unless there is sufficient collateral security irrespective of the rating, history of the relationship, orders on hand or potential of the business. He was emphasising that it was not the case previously.

How it impacts?

The collateral security denominated lending is harming all including the larger society. This does not spare bank who are supposed to be an advantageous position. We list some as below:

1. The borrower will be deprived of cashing in on the opportunity resides in the products and relationship he has built over the years due to non-availability of sufficient working capital.
2. Limiting to the value of collateral security deprive lenders to participating in the growth path of the firm and in turn benefit themselves.
3. Fortune of business may vary from originally planned. The loans secured through mortgages deprive the borrowers to seek alterations in covenants. Banks/NBFCs don’t show flexibility and help in course correction. Rather they brow-beat the borrowers and enforce the recovery action without providing an opportunity for the turnaround. That will result in the destruction of enterprise value.
4. In today’s environment, the intellectual assets play a predominant role in shaping the success of any business venture. Availability of collateral and resulting ability to secure loans does not guarantee the success.
5. The rapid adoption of net-based utilities like industry information, better insight into borrower through rating and other collaterals like CIBIL score, SMA gradation (by RBI) can act as a better indicator of the soundness of proposal and safety of exposure for the bank than merely relying on collaterals. Such vital inputs are treated as additional inputs than primary one in mortgage loans transactions.
6. Many entrepreneurs were allured by the advisors and bankers to enter into new businesses and loans are raised against house property. This all happened without a plan to run the business properly. They eventually faced bankruptcy like situation.
7. Bankers and borrowers tend to ignore the key parameters which determine the success of the project if the lending decision is made on the value of collaterals.
8. Since there is no scrutiny of their plans by anyone else if they raise funds on mortgages to finance their business, SMEs may have to fend for themselves to safeguard their interest in their venture.
9. Many banks have devised loan products on collateral security to reduce the operating expenses in monitoring the exposures. Thus the success of the project is the sole responsibility of entrepreneurs. Hence SMEs in India should not seek comfort in bank’s decision to lend as an endorsement of the business proposal.

Conclusion:

A mortgage is the easiest way to finance the business. However, there exists a chance to ignore the key success factors of the business and high probability of recklessness in spending the loan so raised. SMEs in India should ananlyse the suitability for your business.