Cash Flow Lending

Cash-Flow Lending: A Prudent Shift Within the Credit Landscape?

Banks in India have traditionally followed the concept of lending to companies against their liquidation value of assets and collaterals. Over the years, under this model, banks have extended loans to risk-intensive borrowers on the basis of their assets, which has resulted in higher number of delinquencies as periodic valuation of collaterals are not conducted by most banks.

Below is the graph of Non-Performing Assets (NPA) trend in our banking economy from 2015 to 2020.

In India, where public sector lenders have over 55% share of the loan market, Cash-flow based lending is apt as it is far more structured and looks towards repayment based on the business-projected cash flows. Here, lenders analyse the risk according to the future projections and charge interest rates accordingly. Reserve Bank of India (RBI) Governor Shaktikanta Das has recently stated that banks must focus more on cash-flow based lending instead of relying on collaterals for their lending decisions.

Moreover, most MSMEs books of accounts do not have considerable collaterals. Thus, they can benefit from this model by customizing a loan based on their liquidity and leverage ratios instead of lending purely against assets. It is a more sustained model wherein the working capital is financed by migrating to a cash flow linked system. Many sectors and industries have revenue cycles that are seasonal and asset – based lending does not account for this parameter and typically charges EMI for all 12 months a year.

Due to asset – based lending, schematically, large companies with multiple sources of financing, are over funded by banks whereas the SME / MSME sectors are underfunded due to their inadequate collateral capacity. Under Cash-flow based lending, banks would be able to prioritise their fund deployment program. They will have to consider actual cash inflows and outflows of a firm in deciding the drawing power of commercial borrowers.

At a webinar on investor education organized by National Council of Applied Economic Research (NCAER), the RBI Governor stated,

"To improve the credit to Gross Domestic Product (GDP) ratio, access to credit and cost of credit need to be addressed by lesser reliance on collateral security and greater cash-flow based lending."

Regulatory Developments Over Cash Flow Lending

As of March 2020, RBI issued licenses to three Account Aggregators (AA) that are entities working as intermediary to borrowers. AA will access the borrower’s data from various financial institutions and will work like a ‘Consent Broker’. This will empower Banks and NBFCs to digitally assess the borrowers and review their credit applications instantly.

Also, RBI is in the final stages of identifying entities that will set up a Public Credit Registry (PCR). PCR aims to reduce the risk meter of smaller entities and help them gain loans at lesser interest rates through a registry system of transparent financial records and credit history. It is deemed as an information repository where all information about existing as well as new borrowers is stored. This includes both corporate as well as retail borrowers. The registry captures data on loans taken from all kinds of sources including from banks, NBFCs, corporate bonds, External Commercial Borrowing, Inter-Corporate Lending, etc. It also includes ancillary information like any overdue utility payments, or tax payments data from tax authorities, and other primary information sources.

The proposed PCR will include data from entities like Securities and Exchange Board of India, Corporate Affairs Ministry, Goods and Service Tax Network (GSTN) and the Insolvency and Bankruptcy Board of India (IBBI) to enable banks and financial institutions to get a 360-degree profile of the existing as well as prospective borrowers on a real-time basis.

Unlike Credit Information Bureau India Ltd (CIBIL) or Central Repository of Information on Large Credits (CRILIC) which are Private Credit Bureaus and thus tend to focus on the more profitable data segments, PCR being a non-profit entity will bring forth more comprehensive data coverage and enhance value addition through data analytics, from the largest to smallest borrowers.

Risk Assessment for Cash Flow Lending

Banks & Financial Institutions (FIs) generally focus on SMEs as “High-Risk” profiles for asset as well as cash flow lending. Substantial immovable assets as collaterals is not a strong suit for most SMEs. Lengthy collateral registration processes, depreciation costs or devaluation of assets over lending tenure analysis, the time gap created between revenues and supply due to consignment/service delays, losing business opportunities or diverting funds towards low revenue generating units, all of these add up to the classic risk of non-repayment of loans.

With the advent of cash flow-based lending, the biggest challenge faced by the financiers would be to accurately assess the reliability of the borrowers’ financial reports and projections. To obtain a certain amount of lending, borrowers can prepare fictitious reports, projecting unrealistic cash flows, not in tandem with the business demand-supply cycles.

Also, smaller corporates tend to have poor or no credit references for lenders to understand their business ethical integrity. The documented credit rating of a firm plays a vital role in assessing the major systemic risks generating from their operational, technological and/or financial frameworks that would consequently impact the future cash flows of the entity.

Understanding the Cash Flow Conversion Cycles (CCC) of entities will provide a calculative assessment of how long their cash is tied up in inventory before the inventory is sold and cash is collected in terms of revenues. This will also make the different Risk Assessment Models within the bank more robust and pro-active as these will be churning dynamic cashflow data of the borrower rather than limiting the assessment to purely Business Risk parameters. Typically, businesses take a minimum of 60 days to repay loan instalments and would fail to proceed with the monthly loan cycles.

Also, smaller corporates tend to have poor or no credit references for lenders to understand their business ethical integrity. The documented credit rating of a firm plays a vital role in assessing the major systemic risks generating from their operational, technological and/or financial frameworks that would consequently impact the future cash flows of the entity.

Understanding the Cash Flow Conversion Cycles (CCC) of entities will provide a calculative assessment of how long their cash is tied up in inventory before the inventory is sold and cash is collected in terms of revenues. This will also make the different Risk Assessment Models within the bank more robust and pro-active as these will be churning dynamic cashflow data of the borrower rather than limiting the assessment to purely Business Risk parameters. Typically, businesses take a minimum of 60 days to repay loan instalments and would fail to proceed with the monthly loan cycles.

Understanding the risks associated with the CCC model, will help lenders accurately assess the payment capacity, verify operational documentations, evaluate precise future financial projections and review the durability of borrowing entities, which will assist in customizing cash flow loans as per the requirements of various firms.

The new era of cash-flow lending will aggressively depend upon highly accurate and transparent data, procured by banks and FIs, to appropriately determine their borrower companies’ future revenue projections. Alongside AA and PCR spearheading Credit registry, FinTechs too will implement innovative tools to measure the class of non-salaried borrowers as well. As a new lending foundation, Banks, NBFCs and FIs can look towards quality portfolio growth in their loan books and customers on the other hand, can look forward to easier and customized loan credits with lower interest rates making the lending ecosystem more aligned with actual economic & business cycles.

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