Lending Strategies to Small Businesses in India

Abstract

This study is an understanding of the effectiveness of internal credit ratings approach followed by financial institutions/ banks in their unsecured lending portfolio to small businesses in India in accordance with the Basel Accord. The approach uses the Foundation Internal Ratings Based (IRB) approach to assist the institution compute and manage credit risk. The study helps in understanding the risk profile for each industry segment and its adjunct use in pricing loans. The analysis is extended to Expected and Unexpected losses and required regulatory and economic capital. Using economic capital, I calculate the RAROC to compute the riskiness of the portfolio and requisite portfolio strategy to be adopted in lending. This is done using a binary logistic regression model technique on panel data.

This paper gives an understanding of the internal credit ratings approach followed by banks for Micro, Small and Medium Enterprises (MSME) in accordance with the Basel Accord using the Foundation Internal ratings Based (IRB) approach which helps banks manage their credit risk. It discusses the difference between and suitability of external and internal ratings (Jacobson, Lindé et al. 2005) and the various techniques of modelling credit risk for Unsecured Term Loan Portfolio and helps to understand risk profile for each industry segment and its use in pricing loans This paper further extends the analysis to Expected and Unexpected losses for regulatory and economic capital requirement in accordance with Basel II. Using economic capital, I calculate RAROC which helps us calculate the riskiness of the portfolio and decide on the change in the portfolio to meet the regulatory and the bank requirements.

Limitations: Intangible assets and qualitative analysis is not part of this analysis, though MSME business performance depends to a large extent on intangible assets and related services. Data sample is 2 years old as against 7 years needed for a robust model in Basel II for through-the-cycle approach. Also migration risk is not checked or assumed here.

Keywords: small businesses, credit risk, lending, banking loans

JEL Classification: C33, E59