Subordinate debt: A way for govt to hand out cash to needy MSMEs

On August 19, the government operationalised the Credit Guarantee Scheme for Subordinate Debt for stressed Micro, Small & Medium Enterprises (MSMEs). It had announced this scheme as part of the Aatma Nirbhar Bharat Package. Here’s a look at what the scheme involves and what it means for MSMEs.

What is subordinate debt?

Subordinate debt is a type of debt that an individual or a company can take on and which has a lower priority of repayment. In other words, in the event of liquidation or bankruptcy, the borrower would first pay off other “senior” debt and obligations and only then get to subordinate debt. Subordinate debt is, therefore, riskier than senior debt because there is a much higher chance of it not being repaid.

What does the scheme involve?

The Credit Guarantee Scheme for Subordinate Debt for stressed MSMEs being operated by the Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE) is designed to provide subordinate debt to MSMEs that have stressed accounts or that are already non-performing asset (NPAs). Under the scheme, Scheduled Commercial Banks will provide personal loans to the promoters of stressed MSMEs amounting to 15 per cent of their stake (equity plus debt) or Rs 75 lakh, whichever is lower.

Those MSMEs that have been in regular operations, either as standard accounts or as NPA accounts, during financial years 2018-19 and 2019-20 will be eligible for the scheme. The scheme is valid for MSME units that are stressed and NPA accounts as on April 30, 2020 and that are eligible for restructuring according to RBI guidelines.

The idea behind the scheme is to provide the promoters of these MSMEs enough capital to invest as equity or quasi-equity into the company to aid and smoothen the restructuring process.

Why subordinate debt in such a situation?

Following the announcement of the scheme, questions and criticism arose from various quarters about whether there would be any takers for the subordinate debt since MSMEs that are already stressed would likely not want to take on more debt. This is where the subordinate part of the debt plays its part.

Given its nature, subordinate debt is a more attractive option for borrowers than taking on more conventional debt. The lower priority of subordinate debt in the repayment process eases the pressure on the borrower somewhat. It’s only after all other loans are paid that the subordinate debt needs to be repaid.

At a time when cash flows have dried up, revenue is anaemic and demand subdued, MSMEs starved of liquidity will likely look to the subordinate debt scheme as a lifeline.

The other criticism raised against the subordinate debt scheme is that it would further increase the banks’ NPAs at a time when these are already expected to balloon, thanks to Covid-19 and the lockdown. The scheme seems to take care of this aspect as well.

While the focus has been on the subordinate debt aspect of the scheme, it’s important to remember the “credit guarantee” part as well. According to the scheme’s guidelines, the CGTMSE will guarantee 90 per cent of the subordinate debt given by the banks, with the remaining 10 per cent being covered through a collateral put up by the borrower.

The Ministry of MSMEs has created a fund called the “Distressed Asset Fund – Subordinated Debt for Stressed MSMEs” for the purpose. So far, it has put in Rs 4,000 crore into the fund, with a stipulation that the guarantee amount can go up to Rs 20,000 crore. In other words, there’s no risk for the banks.

So, to recap, the scheme provides liquidity to stressed MSMEs without really burdening them with heavy debt obligations and the banks are guaranteed the loan amount so they don’t have to worry about repayment.

Much like the Emergency Credit Line Guarantee Scheme, which, incidentally, crossed Rs 1 trillion of disbursals recently, the subordinate debt scheme too seems like a way for the government to hand out cash to MSMEs that need it, with no strings attached.