2.2.

3 Interpretation
It is clear that the primary thrust of the rules is to link credit to the current sales
and liquidity
position of the firm. As we saw above, these are both measures that are a part of
the best
practice. What is notable for its absence is profits, either current or projected,
except in as
much as profit are related to turnover or current assets, despite its prominence in
theoretical
literature. Thus two firms with very different costs but the same turnover and
current assets
are supposed to get treated in exactly the same way. It is also worth noting that
the net worth
of the company or the amount of equity available to it enters the calculation of
the loan amount
slightly indirectly—basically a firm that has more equity can sustain a larger
working capital
gap. However under the new system adopted by our bank a firm that has in the
past been
able to sustain a larger working capital gap by virtue of having more equity will,
over a range,
actually get less finance than a firm that has less equity and has therefore
needed more outside
finance in the past. In other words net worth seems to enter with the wrong sign
in many cases.
This is a reflection of the fact that the present approach is need-based and does
not focus on
the fact that firms with more equity may have better incentives. Finally, the rule
is linear: that
8The CVC is an autonomous arm of the government of India with sweeping
powers to investigate charges of
corruption in the public sector.
10
doubling all the numbers in a firm’s balance sheet will imply doubling its credit
limit. Of course
this does not say anything about those who are excluded from getting finance
from the bank,
which is potentially a very important non-linearity.
3 Actual Lending Policy
The lending policy statements gives us the outside limits on what the banks can
lend. There is
nothing in the policies that stops them from lending less though bankers are
always enjoined to
lend as much as possible in all official documents.9 It is also possible, given
that it is not clear
how these rules are enforced, that the banks sometimes exceed the limits—it is,
for example,
often alleged that loan officers in public sector banks give out irresponsibly
large loans to their
friends and business associates. It is not even clear how one would necessarily
know that banker
had lent too much given that he is given the task of estimating expected
turnover. In this section
we therefore look at the actual practice of lending in our sample of loans.
3.1 Data Collection
The data for this study was obtained from one of the better-performing Indian
public sector
banks This bank, like other public sector banks, routinely collects balance sheet
and profit and
loss account data from all the firms that borrow from it and puts it in the firm’s
loan folder.
Every year the firm also has to apply for renewal/extension of its credit line and
the paper-work
involved in this is also stored in the folder along with the firm’s initial
application. The folder
is typically stored in the branch till it is completely full.
With the help of employees from this bank as well as a former bank officer, we
extracted data
from the loan folders in the spring of 2000. The form we used to collect the data
is attached in
appendix. We collected general information about the client (product
description, investment
in plant and machinery, date of incorporation of the units, length or the
relationship with the bank, current limits for term loans, working capital, and
letter of credit). I also collected
summary of the balance sheet and profit and loss account collected by the bank,
and the bank’s
decision regarding the amount of credit to be extended to the firm, and the
interest rate.
There is a comparison between accounts that have always been part of the
priority sector, and accounts that became priority sector in 1998. We first
selected the branches that handle accounts for small and medium enterprises in
6 regions. In each of these branches, we collected the information on all the
accounts that were included in the priority sector after January 1998 (these are
the accounts where the investment in plant and machinery is between 6.5 and 30
million rupees), and a random sample of smaller accounts.
In column 1 of Table 1 we compare our calculation of LTB and the banker’s
calculation of
the same number . In column 2 we compare both the banker’s calculation of
what the limit
should be and our calculation of the same number. Once again we allow some
lattitude: So
we compare not only the banker’s calculation of max LTB,LWC but also his
calculation of
just LTB and just LWC. Likewise we not only compare the loan amount with
our calculation
of max LTB,LWC but also each of the elements separately and LTB calculated,
as above,
according to several different formulas.
The first observation is that the actual amount lent is rarely equal to the limit
that would
be implied by the banker’s calculations: The bankers calculations of max
LTB,LWC is equal to
the actual loan amount only in 10% of the cases. Interestingly the banker’s
calculation of LTB
is more likely to be equal to the actual amount of the loan, but the accuracy is
only marginally
better (12%). Our calculation of what the limit should be does even worse—it
only works in
4% of the cases. A part of the problem is apparent from column 1: The banker’s
calculation of
LTB matches our calculation in only 28% of the cases and is equal to the
amount predicted by
the least stringent of our three methods in 45% of the cases where the banker’s
calculation is
reported (which is only in 54% of the cases).
In table 2, we show that the deviation from this official norm corresponds to a
simple pattern.
In 78% of the cases , the limit actually granted is smaller than the maximum
permitted limit
calculated on the basis of the bank’s stated policy. Most strikingly, in 64% of
the cases for which
we know the amount granted in the previous period, the amount granted is
exactly equal to
the amount granted in the previous period (it is smaller 4% of the times, and
goes up only in
34% of the cases). In figure 1, we show a graph of the relationship between
current loans (in
logarithm) and past loan: it shows a very strong correlation, even for the cases
where the loan
is not exactly equal to the same amount. Given that that inflation rate is 5% or
higher, the
real amount of the loans therefore decreases between two adjacent years in a
majority of the
13
cases and to make matters worse, in 73% of these cases the firm’s sales has
increased, implying,
one presumes, a greater demand for working capital. Further, this is the case
despite the fact
that according to the bank’s own rules, the limit could have gone up in 64% of
the cases (and
as already mentioned, getting a higher limit is simply an option and does not
cost the firm
anything unless it uses the money). Figure 2 shows a correlation of the official
limit with past
loans: while the two are correlated, they are much less strongly linked than
current loans and
past loans. Finally, this tendency seems to become more pronounced over time:
in 1997, the
limit was equal to the previous granted limit 53% of the time. In 1999, it did not
change in 70%
of the cases.
In table 3, we regress the reported limit on turnover basis and the actual
working capital
limit granted on some of the information available to the bank when the
decision was taken.
We take the logarithm of all variables. In column (1) and (2), we examine
determinants of
the bank’s calculation of the limit on turnover basis. In column (1), we regress
the log of the
bank’s limit on turnover basis on the values generated using three different rules
— the log of
0.20*projected turnover, the log of (0.25*projected turnover-available margin),
and log of LWC.
We also include the variables which the US literature suggest should be taken
into account: the
logarithm of profit over asset12, a dummy for whether the firm as negative
profit, the logarithm
of the ratio of tangible net worth over total debt, the logarithm of assets. All
three rule-based
variables are strongly significant, and none of the other variable is significant.13
The fact they do
not enter this regression could be due to the fact that it is taken into account in
the estimation
of the projected turnover. In column (2), we replace the projected turnover as
calculated by
the bank by current turnover (one of the bank’s documents specifies that the
projected turnover
can be calculated by adding 15% to the current turnover). Assets is now
significant, and the
current sales variables are jointly less significant: this suggest that the current
level of assets is
used in combination with current sales to determine future sales. Profits and net
worth still do
not enter this regression.
In column (3) to (8), we turn to the determinants of the actual limit granted. Not
surprisingly,
given everything we have said, past loan is a very powerful predictor of today’s
loan. The R-
12Set to 0 if the firm as negative profit
13A F test strongly reject that they are jointly significant.
14
squared of the regressions is also very high (over 95%) in all the regressions
that include past
loans as a control. In column (3), we regress current loan amount on past loan
amount and the
limit according to the bank rule (the maximum of ltb calculated by the banker
and lwc). Since
the bank’s rule never refers to past loan as a determinant of the loan amount to
be given out,
past loan should not be an important determinant of current loan once we
control for what the
rule prescribe. Instead, the coefficient of past loan is 0.757, with a t statistic of
18 (a one percent
increase in past loan is associated with a 0.756% increase in current loan, after
controlling for
the official rule). The maximum limit is also a significant determinant of loan
amount, with a
coefficient of 0.256. The standard deviation of these two variable is very close
(1.50 and 1.499
respectively). These coefficient thus means that a one standard deviation
increase in the log of
the previous granted limit increases the log of the granted limit by 3 times as
much as a one
standard deviation increase in the log of the maximum limit as calculated by the
bank. The sum
of the two coefficients is not significantly different from one, suggesting that
constant returns to
the size of the firm: if all factors are multiplied by the same factor, the new
granted limit will
also be multiplied by this amount.
In column (4), we “unpack” the official limit: we include separately the bank’s
limit on
turnover basis (ltb), our the limit based on the traditional method (lwc), and the
logarithm
of profits. As in the previous regression, past loan is the most powerful
predictor of current
loan. Both limits enter the regression. The weight of the measure based on
current asset and
liabilities is somewhat higher (the two variables have similar standard
deviations.) Neither the
log of profit nor the dummy for negative profit enter the regression. The log of
tangible net
worth over total debt is significant and negative. While this is contrary to the
recommendations
of the US literature, this is probably a consequence of the fact that a higher net
worth make
the firm less dependent on outside financing, and thus reduce the limit it is
entitled to. Again,
these results could be due to the fact that the limit on turnover basis (which is
calculated by the
banker and seems to incorporate other elements than the projected turnover)
incorporates all
relevant information about the prospects of the firm. In column (5), we regress
lending on past
lending, our calculation of ltb based on the turnover projected by the bank, and
the traditional
limit (lWC). LWC and LTB calculated based on projected turnover are both
significant. Current
profit is still insignificant, the coefficient of net worth is negative, and the
coefficient of asset
15
is now positive and significant. Since the turnover projection may in turn
incorporate all the
relevant information the bank has on the future profitability of the firm, we
replace in column
(6) projected turnover by an interpolated value based on today’s turnover.
Profits remain
insignificant, the importance of asset raises, and the coefficient of net worth is
still negative.
Note that as we replace the ltb calculated by the bank by ltb calculated using
less and less
information in column (5) and (6), its coefficient drops: our calculation of ltb is
insignificant in
column (6). This indicates that the bank does put some weight on the
information they gather
on the clients.
In column (7) and (8) we include in addition a measure of the utilization by the
client of
the limit granted to him in the previous year, the ratio of interest earned by the
bank and the
account on the limit. This is clearly of direct interest to the bank, since it looses
money when
funds are committed, but not used. This is collected by them as part of the data
on conduct
of account. Yet, this variable is uncorrelated with granted limit. We tried other
measures of
utilization of the limit (turnover on the account divided by granted limit, and
maximum divided
by granted limit), and none of these measures are significant.
In sum, the actual policy followed by the bank seems to be characterized by
inertia, combined
with lending based on the size of the firm: To the extent that limits do change,
what seems to
matter is the size of the firm, as measured by its sales and the scale of its
operation. Neither
the profitability of the firm’s operation nor the utilization of the limit by the
client seem to
determine the amount lent.
In table 3b, we investigate the determinants of interest rates. The interest rate
policy is
characterized by even more inertia: past interest rates is the only significant
determinant of
today’s interest rates. Past loans, ltb (calculated by us or by the banker) and lwc
do not enter
the regression, nor are any of the financial ratio that we include in the
regression.
4 Interpreting Bank Lending Behavior
In columns (1) to (6) of table 5, we run the same regression that we used in the
previous
section to predict the amount of loan, but now treating separately the firms
according to how
long they have dealt with the bank. Specifically, we group the firms into those
who have been
client of the bank for 5 year or more, and those who have been clients for less
than 5 years (5
years is the median relationship between the bank and the client). The results
are presented
in the odd columns for the old clients, and in the even columns for the recent
clients. Clearly,
banks do not put less weight on the past loans for recent clients than for old
clients. If anything,
when we include today’s sale (and not the bank’s prediction of tomorrow’s
sale), the bank seem
to put more weight on past loans for recent clients than for old clients.
A different way of judging whether the bank’s behavior makes sense is to ask
whether the
variables that seem to determine the bank’s lending also predict outcomes that
the banks usually
care about. These include future profits, because more profitable firms are
perhaps less likely to
default14 and less indirectly, delay in repayment and actual default. In column
(7) and (8), we
look at the correlation between future profits and the variables used by the bank
to determine
the limit. In column (9) and (10) and (11), we look at whether these variable
predict the
occurrence of negative profits (which themselves predict default). In column
(12) to (13), we
14As is well-known this is not always true. A firm that makes more money
could also be taking on more risk.
A regression of future default on profit does not lead to a positive coefficient.
However, A firm whose profits
are negative in one period is more than three times as likely to be a NPA or
experience delay in payment in the
following period than other firms (6.7% versus 1.8%, and this difference is
significant.
17
look at whether they directly predict default.15 Current profit is a good
predictor of future
profit, and the variables that the bank uses (past loans, etc...) are not. The only
good predictor
of future negative profit is current negative profit. Turning to default rate
directly16, ltb and
lwc do not predict default. Assets (which is positively correlated with lending)
does predict
more default. Negative profit predict more default (although the coefficient is
not significant
in the full regression). The only variable that is negatively correlated with future
default and
positively correlated with lending is future sales.
A related but different approach is to look at the correlation between loans and
future
profitability. If the loans are well-targeted, this correlation should be positive.
More generally,
it should be exceed the causal effect of loans on profits. In the next section, we
take advantage of
a natural experiment to estimate the causal effect of loans on profits. At the end
of that section,
we will compare the OLS coefficient to this estimate. We find that the OLS
coefficient of loans
in the profit regression is smaller than the IV coefficient, which suggest that, at
a minimum,
banks are not screening projects according to their profitability.
5 Are firms really credit constrained?
The cumulative impact of the previous section suggests a picture of the Indian
banking sector
where firms can only get more loans by increasing their turnover and even then
what they can
get is severely limited by what they already had. In other words, it has
appearance of a severely
credit constrained economy. However all this would be moot unless we could
show that there
are firms that can profitably absorb more credit at the going interest rate.
The problem is, as often in economics, in finding an appropriate experiment to
answer this
question. It is clearly not very useful to compare the firms that got more credit
with those
that did not. There is now a large number of well-known papers that have
struggled with the
identification problem inherent in this exercise. Here, we make use of an
extension of the priority
sector, which provides an arguably exogenous variation in credit available to the
firm.
15We used also set the default variable equal to one if the account currently
experienced a delay in interest
payment.
16These results need to be taken carefully because we many not have the
correct default variable
18
5.1
In table 6, we run a set of simple difference in differences regressions, using as
dependent
variables several attributes of the lending policy of the bank vis a vis the
particular firm . For
each variable, we run the specification:
yit − yit−1 = _BIGi + _POSTt + BIGi _ POSTt + _it, (3)
where yit is an outcome variable for firm i in year t.18 We run the regression,
both in the entire
sample, and in the sample for which we have information about the profits in
the next year
(which leaves out enhancements given in 1999, since we do not have profits for
the year 2000).
18Standard errors are corrected for clustering at the firm level.
20
The results are similar in both samples.
In columns (1) and (2), we use the logarithm of the sum of the working capital
limits from
all banks as the outcome variable. As the descriptive statistics in table 5
suggested, we find a
positive and significant coefficient for the interaction big*post: Relative to
small firms, big firms
enjoy larger increase in their working capital limit. In columns (3) and (4), we
use the working
capital limit granted by our bank—the results are very similar. In columns (5)
and (6), we use
the interest rate as the dependent variable: they are essentially unaffected (and
not significantly
different across small or big firms or over time). This is not surprising, since the
bank has only
a limited margin to modify interest rate.
5.3 Effect on Firm’s performance
In table 7, we use the same specification to examine the effect of the policy on
the firms’
performance.19 We first look at the increase in the logarithm of net profit
between year t and
t+1 (for a loan granted in year t).20. The coefficient of the interaction is positive
and significant,
with a very high point estimate: Between 98 and 99, the rate of increase in
profits is higher for
big firms faster than that of small firms, whereas the reverse was true between
96 and 98.
In column (2), we use changes in the logarithm of sales as the dependent
variable. The
coefficient of the interaction big*post is positive, as in the profit regression, and
significant at
the 10% level. The effect of the reform on profit is larger than its effect on sales,
which is what
we might have expected.
In column (3), we use as dependent variable a dummy for whether the firm’s
profits have
become negative between the two periods. None of the coefficient is significant:
thus, at least in
19The regressions in this table, and in all the tables that follows, are feasible
generalized least square, to
minimize the variance of the estimates. In the first step, the regression is run. In
the second step, the regression
is run again, and the observation for which loan amount did not change receive
a weight proportional do the
squared root of the ratio of the sum of squared deviation excluding observations
for which the increase is not 0
to the sum of squared deviation for the observation for which it is 0. This gives
less weight to the observations
for which the loan did not change, which have much more noise.
20When profit are negative in both period, we replace log(profitt+1
log(profitt
with its negative. When profits are positive
one period and negative the next period, this is not defined. This could
potentially introduce a sample selection
problem, but the next column shows that large firms are no more likely to start
having negative profit and small
firms after the reform: the sample selection is thus not correlated with the
interaction big _ post.
21
the short run, big firms are no more likely to become fragile after they receive a
larger increase
in their loans than the small firms. In column (4), we use a dummy indicating
whether the
account has become a non-performing asset (NPA) or whether it interest
payments have started
becoming delayed between the two periods as the dependent variable. Again,
large firms are not
more likely to have become NPA or to go into delay. Increasing the limits for
the firms has not
resulted in an immediate worsening of the probability of repayment.
In column (5), we test another implication of the idea that the firms are credit
constrained:
if they had enough credit before, the rate at which they use their limit should
have gone down
after the reform. In this regression, we measure utilization by the ratio of the
interest earned
by the bank to the limit granted (we used alternative measure, such as maximum
balance over
granted limit, and turnover over granted limit, with the same results). The rate
of utilization is
not affected by the reform, suggesting that they use the new funds as intensively
as the funds
they were getting before.
In column (6), we look at whether they substitute bank credit for trade credit.
We measure
trade credit as the ratio of other current liabilities over current assets: this
measure the extent to
which they relies on advance payment and credit from their suppliers to finance
their production.
There is a modest positive effect of the reform on this variable, but it is far from
being significant.
The new bank thus correspond to a large net increase in credit.
5.4 Instrumental Variables Estimation: Effect of loans on profits and sales
Table 6 and 7 are of independent interest, since they tell us the effect of
becoming a part of the
priority sector on credit, profits, and sales. Under the assumption that there is no
other effect
for the firms of being included in the priority sector, other than the increase in
loans, we can
use the policy as an instrument for the effect of loans on profits and sales.
There are three other ways in which being a part of the priority sector may
affect firms.
First, it can receive more term loans, as well as working capital loans (since
term loans to SSI
can help banks fulfill their priority sector quota as well). Second, some product
are reserved for
the SSI sector. Third,
22
with. Nevertheless, we collected data on the level of term loans received by the
firms. In column
(7) and (8) of table 6, we use the increase in the logarithm of term loans as the
dependent
variable, in the full sample and in the sample for which we have profit data. In
neither samples
is there is a significant increase in the amount of term loans received by large
firms after the
extension of the priority sector.
To address this issue, we will restrict the sample to firms that do not produce a
product restricted to SSI.