to evolve its own lending policy, under the condition that it be made explicit. Moreover the Nayak committee recommended that the turnover rule be used to calculate the lending limit for all loans under Rs. 40 millions.
Given the freedom to choose the rule, different banks went for slightly different strategies. The bank we studied adopted a policy which was, in effect, a mix between the now recommended turnover-based rule and the older rule based on the firm’s asset position. First the limit on turnover basis was calculated as:
min(0.20 ∗ Projected turnover, 0.25 ∗ Projected turnover − available margin)
The available margin here is the financing available to the firm from long term sources (such as equity), and is calculated as Current Assets − Current Liabilities from the current balance sheet. In other words the presumption is that the firm has somehow managed to finance this gap in the current period and therefore should be able to do so in the future. Therefore the bank only needs to finance the remaining amount. Note that if the firm had previously managed to get the bank to follow the turnover based rule exactly, its available margin would be precisely 5 percent of turnover and the two amounts in 6 would be equal.
The rule did not stop here. For all loans below Rs 40 million (all the loans in our sample are below 40 million), the loan officer was supposed to use both equation 6 and the older rule represented by 5. The largest permissible limit on the loan was the maximum of these two numbers.
Two comments about the nature of this rule are in order. First, this turnover based approach to working capital finance is relatively standard even in the USA. However the view in the USA is that working capital finance is essentially financing inventories and is therefore backed by the value of the inventories. In India, the inventories do not seem to provide adequate security, as evidenced by the high rates of default. In such cases it may be much more important to pay attention to profitability, since profitable companies are less likely default. Second, in the USA the role of finding promising firms and promoting them is carried out, to a significant extent, by venture capitalists. In India the venture capital industry is still nascent and it will be a while before it can play the role that we expect of its US equivalent. Therefore banks may have to be more pro-active in promoting promising firms. Following a rule that does not put any weight