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Historically, industrial borrowers in India often had relatively easy access to bank loans to cover their working capital needs. The cash credit arrangement, a primary method for providing such finance, was particularly advantageous for borrowers.
What Was the Historical Context of Bank Loans in India?
The ready availability of convenient financing led many observers of the Indian banking sector to believe that industries were over-borrowing, potentially at the expense of other economic sectors. Concerned about this imbalance in credit allocation, the Reserve Bank of India (RBI) began efforts, particularly since the mid-1960s, to instill greater discipline among industrial borrowers and redirect credit towards priority sectors of the economy.
Over time, the RBI issued guidelines and directives, often based on recommendations from specially formed groups tasked with examining various aspects of bank lending to industries.
What Were the Dehejia Committee's Key Findings?
In 1968, the National Credit Council established the Dehejia Committee to investigate whether the credit needs of industry and trade were inflated and to propose methods for addressing this issue. The committee analyzed the growth rates of short-term credit compared to industrial production, as well as short-term trade credit and inventories held by industry and trade. They also examined instances where short-term credit was diverted for acquiring fixed assets or for other investments.
The Dehejia Committee's primary findings included:
- Bank credit to industry was growing at a faster rate than industrial output.
- Banks generally linked credit limits to the security provided by borrowers, rather than thoroughly assessing their actual needs based on projected financial requirements.
- Short-term bank credit was, to some extent, being diverted to finance fixed assets and other non-working capital purposes.
What Changes Did the Dehejia Committee Suggest?
The Dehejia Committee proposed several key changes to improve credit discipline and allocation:
- Credit applications should be evaluated based on the borrower's current and projected financial situation, using cash flow analyses and forecasts.
- Cash credit accounts should be split into two parts: a "hard-core" component, representing the minimum current assets needed for a given production level, and a "strictly short-term" component, covering fluctuating needs.
- To prevent multiple financing, customers should ideally deal with only one bank. For high credit requirements, a consortium arrangement among banks should be adopted.
- The typical trade credit period should not exceed 60 days, with a maximum of 90 days in special circumstances.
- To discourage borrowers from seeking more credit than necessary, a commitment charge should be levied, potentially with a minimum interest charge.
- Commercial banks should encourage the use of bills of exchange, which can strengthen financial discipline for purchasers and help suppliers plan their finances more realistically.
- When granting loans, banks should carefully assess the adequacy of inventory levels across various industries and explore opportunities to minimize required stock.
How Were Lending Styles and Information Systems Addressed?
The committee observed that the existing cash credit system, which allowed borrowers to draw freely within sanctioned limits, hindered sound credit planning for banks and could lead to financial indiscipline for borrowers. Furthermore, a security-oriented lending approach favored financially strong borrowers and often resulted in the diversion of funds (borrowed against current assets) to finance fixed assets. This easy access to working capital often led to high inventory levels and meant that what was theoretically short-term working capital finance effectively became a long-term funding source.
To better regulate bank credit, several factors needed consideration:
- Norms for inventory and receivables.
- The quantum of permissible bank finance.
- The style of lending.
- The information and reporting system.
Regarding the style of lending, experts suggested that the overall credit limit could be divided into a loan component, representing the minimum year-round borrowing, and a demand cash credit component for fluctuating needs, both to be reviewed annually. While flexibility was important, the demand cash credit component could carry a slightly higher interest rate than the loan component, incentivizing better financial planning by the borrower. Similarly, any term loan for excess borrowing, amortized over time, could also have a slightly higher rate than the standard cash credit rate.
Beyond traditional loans and cash credit, a portion of the total eligible credit could be provided through bill limits to finance seller's receivables. It was deemed preferable to finance receivables via bills rather than cash credit against book debts. For financing purchases (whether by cash credit or bills), individual banks, in consultation with borrowers, could make decisions based on the borrower's operational size, transaction specifics, and the bank's