-Vinod Kothari (email@example.com)
Economic recoveries in the past have always happened by increasing the supply of credit for productive activities. This is a lesson that one may learn from a history of past recessions and crises, and the efforts made by policymakers towards recovery. [See Appendix]
The above proposition becomes more emphatic where the disruption is not merely economic – it is widespread and has affected common life, as well as working of firms and entities. There will be major effort, expense and investment required for restarting economic activity. Does moratorium merely help? Moratorium possibly helps avoiding defaults and insolvencies, but does not help in giving the push to economic activity which is badly needed. Entities will need infusion of additional finance at this stage.
The usual way governments and policy-makers do this is by releasing liquidity in the banking system. However, there are situations where the banking system fails to be an efficient transmission device for release of credit, for reasons such as stress of bad loans in the banking system, lack of efficient decision-making, etc.
In such situations, governments and central banks may have to do direct intervention in the market. Governments and central banks don’t do lending – however, they create institutions which promote lending by either banks or quasi-banks. This may be done in two ways – one, by infusion of money directly, and two, by ways of sovereign guarantee, so as to do credit risk transfer to the sovereign. The former method has the limit of availability of resources – governments have budgetary limitations, and increased public debt may turn counter-productive in the long-run. However, credit risk transfer can be an excellent device. Credit risk transfer also seems to be creating, synthetically, the same exposure as in case of direct lending by the sovereign; however, there are major differences. First, the sovereign does not have to go for immediate borrowings. Second and more important, the perceived risk transfer, where credit risk is shifted to the sovereign, may not actually hit in terms of credit losses, if the recovery efforts by way of the credit infusion actually bear fruit.
The write-up below suggests a product that may be supported by the sovereign in form of partial credit risk guarantee.
Genesis of the loan product
For the sake of convenience, let us call this product a “wrap loan”. Wrap-around mortgage loans is a practice prevalent in the US mortgage market, but our “wrap loan” is different. It is a form of top-up loan, which does not disturb the existing loan terms or EMI, and simply wraps the existing loan into a larger loan amount.
Let us assume the following example of, say, a loan against a truck or a similar asset:
|Original Loan amount||1000000|
|Rate of interest||12%|
|Number of months the loan has already run||24||Months|
|Number of remaining months of original loan term||36||Months|
|Principal outstanding (POS) on the date of wrap loan||₹ 6,69,724.82|
For the sake of convenience, we have not considered any moratorium on the loan. The customer has been more or less regular in making payments. As on date, he has paid 24 EMIs, and is left with 36. Now, to counter the impact of the disruption, the lender considers an additional loan of Rs 50000/-. Surely, for assessing the size of the wrapper loan, the lender will have to consider several things – the LTV ratio based on the increased exposure and the present depreciated value of the asset, the financial needs of the borrowers to restart his business, etc.
With the additional infusion of Rs 50000, the outstanding exposure now becomes Rs 719725/-. We assume that the lender targets a slightly higher interest for the wrapper part of the loan of Rs 50000, say 14%. The justification for the higher interest can be that this component is unsecured. However, we do not want the existing EMI, viz., Rs 22244/- to be changed. That is important, because if the EMIs were to go up, there will be increasing pressure on the revenues of the borrower, and the whole purpose of the wrap loan will be frustrated.
Therefore, we now work the increased loan tenure, keeping the EMIs the same, for recovering the increased principal exposure. The revised position is as follows:
|POS on the date of wrap loan||₹ 6,69,724.82|
|Additional loan amount||50000|
|Interest on the additional loan||14%|
|Blended interest rate||12.139%|
|Revised loan tenure||39.39||months|
|total maturity in months (rounded up)||40||months|
|Number of whole months||39||months|
|Fractional payment for the last month||₹ 8,664.67|
Note that the blended rate is the weighted average, with interest at the originally-agreed rate of 12% on the existing POS, and 14% on the additional amount of lending. The revised tenure comes to 39.39 months, or 40 months. There will be full payment for 39 months, and a fractional payment in the last month.
Thus, by continuing his payment obligation for 3-4 more months, the borrower can get Rs. 50000/- cash, which he can use to restart his business operations.
The multiplier impact that this additional infusion of cash may have in his business may be substantial.
Partial Sovereign Guarantee for the Wrapper Loan
Now, we bring the key element of the structure. The lender, say a bank or NBFC, will generally be reluctant to take the additional exposure of Rs 50000, though on a performing loan. However, this may be encourage by the sovereign by giving a guarantee for the add-on loan.
The guarantee may come with minimal actual risk exposure to the sovereign, if the structure is devised as follows:
- The sovereign’s portion of the total loan exposure, Rs 719725, is only Rs 50000, which is less than 10%. A safe limit of 10% of the size of the existing exposure may be kept, so that lenders do not aggressively push top-up loans.
- Now, the sovereign’s portion, which is only Rs 50000/- (and in any case, limited to 10%), may either be a pari-passu share in the total loan, or may be structured as a senior share.
- If it is a pari-passu share, the question of the liability for losses actually coming to the sovereign will arise at the same time as the lender. However, if the share of the sovereign is a senior share, then the sovereign will get to share losses only if the recoveries from the loan are less than Rs 50000.
The whole structure may be made more practical by moving from a single loan to a pool of loans. The sovereign guarantee may be extended to a pool of similar loans, with a prescription of a minimum number, maximum concentration per loan, and other diversity parameters. The moment we move from a single loan to a pool of loans, the sharing of losses between the sovereign and the originator will now be on a pool-wide basis. Even if the originator takes a first loss share of, say, 10%, and the sovereign’s share comes thereafter, the chances of the guarantee hitting the sovereign will be very remote.
And of course, the sovereign may also charge a reasonable guarantee fee for the mezzanine guarantee.
Since the wrapper loan is guaranteed by the sovereign, the lender may hope to get risk weight appropriate for a sovereign risk. Additional incentives may be given to make this lending more efficient.
Economic recovery from a crisis and the role of increased credit supply: Some global experiences
- Measures by FRB during following the Global Financial Crisis:
‘The first set of tools, which are closely tied to the central bank’s traditional role as the lender of last resort, involve the provision of short-term liquidity to banks and other depository institutions and other financial institutions. A second set of tools involved the provision of liquidity directly to borrowers and investors in key credit markets. As a third set of instruments, the Federal Reserve expanded its traditional tool of open market operations to support the functioning of credit markets, put downward pressure on longer-term interest rates, and help to make broader financial conditions more accommodative through the purchase of longer-term securities for the Federal Reserve’s portfolio.’
- Liquidity shocks may cause reverse disruption in the financial chain:
‘During a financial crisis, such “liquidity shock chains” can operate in reverse. Firms that face tightening financing constraints as a result of bank credit contraction may withdraw credit from their customers. Thus, they pass the liquidity shock up the supply chain; that is, their customers might cut the credit to their customers, and so on…..Thus, the supply chains might propagate the liquidity shocks and exacerbate the impact of the financial crisis.’
- Measures taken during Global Financial Crisis – US Fed publication – From Credit Crunches to Financial Crises:
Therefore, many of the policy remedies proposed to alleviate credit crunches were, in fact, used during the early stages of the 2008 financial crisis to mitigate potential credit availability problems. These remedies included capital infusions into troubled banks, the provision of liquidity facilities by the Federal Reserve, and, in the initial stress test, a primary focus on raising bank capital rather than allowing banks to shrink assets to maintain, or regain, required capital ratios.
- Observations of Banca Italia on the 2008 Crisis
‘First, the effect of credit supply on value added is not detectable in the years before the great recession, indicating that credit supply is more relevant during an economic downturn. Second, the reduction in credit supply also explains the decline in employment even if the estimated effect is lower than that on value added. As a result, we can also detect a significant impact on labor productivity, while there is no effect on exports and on firm demographics. Third, the role of credit supply does vary across firms’ size, economic sectors, degree of financial dependence and, consequently, across geographical areas. Specifically, the impact is concentrated among small firms and among those operating in the manufacturing and service sectors. The impact is also stronger in the provinces that depend more heavily on external finance’
 In fact, the wrap loan could have been an effective alternative to the moratorium
Our other content relating to COVID-19 disruption may be referred here: http://vinodkothari.com/covid-19-incorporated-responses/
Our FAQs on moratorium may be referred here: http://vinodkothari.com/2020/03/moratorium-on-loans-due-to-covid-19-disruption/