Bank Ownership and the Quality of Intermediation
Limitations on Public Sector Banks
Official Lending Policies
While public sector banks in India are nominally independent entities, they are subject to intense regulation by the Reserve Bank of India (RBI). This includes rules about how much a bank should lend to individual borrowers–the so-called “maximum permissible bank finance.” Until 1997, the rule was based on the working capital gap, defined as the difference between the current assets of the firm and its total current liabilities excluding bank finance (other current liabilities). The presumption is that the current assets are illiquid in the very short run and therefore the firm needs to finance them. Trade credit is one source of finance, and what the firm cannot finance in this way constitutes the working capital gap.
Firms were supposed to cover a part of this financing need, corresponding to no less than 25 percent of the current assets, from equity. The maximum permissible bank finance under this method was thus:
0.75 ∗ CURRENT ASSETS − OTHER CURRENT LIABILITIES
The sum of all loans from the banking system was supposed not to exceed this amount.23 This definition of the maximum permissible bank finance applied to loans above Rs. 20 million. For loans below Rs.20 million, banks were supposed to calculate the limit based on the projected turnover of the firm. Projected turnover was to be determined by a loan officer in consultation with the client. The firm’s financing need was estimated to be 25 percent of the projected turnover and the bank was allowed to finance up to 80 percent of what the firm needs, i.e. up to 20 percent of the firm’s projected turnover. The rest, amounting to at least 5 percent of the projected turnover has again to be financed by long term resources available to the firm.
In the middle of 1997, following the recommendation of the committee on financing of the small scale industries (the Nayak committee), the RBI decided to give each bank the flexibility
23 Thus, a particular bank had to deduct from this amount, the credit limits offered by other banks. Following this rule implies that the current ratio will be over 1.33, and the rule is often formulated as the requirement that the current ratio exceeds 1.33.