A lender ban isn't the answer to India’s credit excesses

By Andy Mukherjee

A big chill has descended on India’s credit industry since the RBI last week asked four finance companies to stop giving out new loans. A bond sale by one of the firms got canceled; shares in the owner of another plunged. Nervous investors, already fretting over emerging stress in household finances, are wondering what other regulatory action lies ahead.

The Reserve Bank of India said that the interest rates charged by the firms were “excessive.” In addition to “usurious pricing,” these nonbank financiers were allegedly guilty, to various degrees, of “non-adherence with the regulatory guidelines on assessment of household income and consideration of existing/proposed monthly repayment obligations in respect of their microfinance loans,” the RBI said.

In other words, the central bank is worried about subprime borrowers falling into a debt trap. But while that’s a serious concern, even a temporary ban may be counterproductive if the flow of capital to nonbank lenders dries up. After the US and the UK, India has the world’s third-highest share of credit that relies on short-term funding, and is not directly created by bank deposits.

At least two of the four lenders have high-profile backers. DMI Finance Pvt. has equity from Japan’s Mitsubishi UFJ Financial Group Inc. Navi Finserv Ltd. was started by Sachin Bansal, a billionaire cofounder of Flipkart, after the Indian e-commerce platform was acquired by Walmart Inc. These are sizeable businesses. DMI gave out $2.25 billion last financial year for personal loans, to purchase household appliances, and to tiny firms as working capital. The money came from banks and from investors to whom DMI sold the loans after pooling and packaging them as securities. Navi had a $1.3 billion portfolio in June, of which 89 per cent were digital personal loans. On Monday, it scrapped a planned bond sale.

The other two banned firms are microfinance institutions that seek borrowers at the bottom of the pyramid. One of them postponed an initial public offering last month. That was probably just as well. The stock of its owner, Manappuram Finance Ltd., fell 21 per cent over three trading days in response to the RBI’s regulatory order.

The subprime lending boom that the Indian regulator is trying to tame predates Covid-19. An early sign of excesses came in 2019 when less creditworthy customers began to dominate new credit-card signups. The spike in post-pandemic inflation and an uneven recovery that bypassed working-class families has aggravated the challenge. As has the spread of digital lending: Navi considers reaching customers with “disbursals in under 10 minutes” as one of its strengths. DMI is available to 25 million customers across 95 per cent of all postal codes in a continent-sized geography.

The RBI, which raised capital requirements against some consumer credit last November, was aware of the stress accumulating on household balance sheets. It must also know the credit industry’s worst-kept secret: The fixed obligation to income ratio, or FOIR, a metric for assessing how much of a borrower’s income is already earmarked for meeting other debt repayments, rent and insurance premiums, is subjective and useless.

Income — the “I” in FOIR — is tough to measure in a country with a large informal economy. In 2022, only about 26 per cent of people in regular employment had long-term work contracts. The income data is hard to validate for salaried employees, and almost impossible to pin down for the self-employed. One way to make the economics of loans work may be to overlook the inconsistencies when borrowers overreport — and charge them exorbitant interest to compensate for the risk of not getting repaid.

Navi’s personal loans came with interest rates ranging between 9.9 per cent and 45 per cent. After discussions with the RBI, the digital lender cut the top rate to 35 per cent in May. Yet it was slapped with a ban. Although the industry wants specific guidance, it would be problematic if the RBI spells out hard caps on interest. That would just push the more desperate borrowers toward unregulated moneylenders. With consumer credit already starting to slow, asking lenders to bring in additional equity would be a more sensible approach. Let there be a thicker cushion of private capital to absorb losses from delinquencies. Credit costs have already started rising.

Regulatory bans, even for a few quarters, might end up aggravating the downturn. They would scare away potential sources of capital; salespeople will leave. The players that have been given the cease-and-desist orders are at risk of banks recalling loans to them citing the RBI’s embargo as a material adverse effect. So far, banks haven’t used that nuclear option. Still, the nonbank industry is worried. It simply doesn’t know which of its business practices could suddenly invite the regulator’s wrath.

Even subprime lenders that underwrite subsidized affordable-housing loans slap a near-9 per cent spread on their 8 per cent-plus cost of capital to charge 17 per cent. The markup may also be considered usurious by some. But if the RBI stops such high-cost borrowing, what alternative will blue-collar workers have to own a roof over their heads? Banks aren’t keen to serve them, which is why they go to finance companies in the first place.

I wrote a year ago that India’s masses are keeping their heads above water by getting deeper into debt. Inflation-adjusted wages of regular salaried workers have declined over the past decade. If this slow-moving household economy is now skidding on the shiny rails of high-speed digital financing, the answer is more job creation and stronger wages in modern, productive industries. That isn’t something the RBI can help fix — certainly not with lending bans.