The Mudra problem

Directed lending always builds up bad loans in banks

On Tuesday, Reserve Bank of India Deputy Governor M K Jain highlighted a dangerous trend: The rising levels of bad debt in the small-scale loans being handed out under the government’s Mudra scheme. The location where he made this remark is significant: He was speaking at a microfinance conference organised by the Small Industries Development Bank of India, which is the underwriter and the owner of the risk management protocols for the Mudra loans. Mr Jain said that banks would have to do both a better job of establishing the capability to repay when the potential loan is being evaluated, and also “monitor the loans through the life cycle much more closely”. Although Mudra loans are typically relatively small in size, a large number of them has been handed out and they are generally free of collateral, making them a significant point of vulnerability for banks that are just beginning to emerge from an existing crisis. It is not surprising, therefore, that the banking regulator is worried — even the Governor, Shaktikanta Das, has raised concerns about this in the past.

These concerns are entirely warranted. When collateral-free loans were first suggested, it was foreseen by many that the consequences would be a worrisome increase in bad debt. The question is certainly one of capacity, as the regulator seemed to argue. The number of Mudra loans is so large that the capacity to both evaluate and monitor is significantly constrained, especially at the level at which these loans are being handed out. Yet even beyond capacity, there are problems of intent that must be taken on board. The simple fact is that the government has made it very clear that handing out money through Mudra loans is a political priority. Senior politicians in the ruling party have consistently mentioned the amount and number of Mudra loans as an achievement, and tied it to claims about entrepreneurship and even job creation. Given these clear political signals, it would be futile to expect any change in how the programme is being implemented on the ground. No banker in the state sector is likely to defy a clearly stated government preference. 

This combination of directed lending and a high presence for the state in the banking sector is a recipe for disaster. Government orders to the banking sector, whether sectoral or of the sort that the Mudra programme is, are detrimental to the due diligence work that is integral to a healthy financial sector. Loans where there is a government mandate are always going to be scrutinised differently than those where the bank’s own concerns are at stake. The constraints put on the loan are substantially different. If the government wishes to retain a large stake in the banking sector, then it must realise that it simply cannot hand out directives. As in any bureaucracy, there will be a rush to comply with orders but such a rush is fatal to the health of the banking sector. Directed lending in a system like India’s leaves the banking sector susceptible to crises.