Retail Lending - Arms Lending Report.pdf · RETAIL LENDING UNTIL NOW 1.1 Defining retail loans ......

Contents

1. RETAIL LENDING UNTIL NOW 3

2. EVOLVING PRACTICES 11

3. DIFFICULT TIMES 19

4. FINE TUNING THE RETAIL LENDING MODEL 22

5. CONCUSION 25

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Retail Lending

Balancing Concerns in Difficult Times

Author:

Hari Misra

Editor-in-Chief

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1. RETAIL LENDING UNTIL NOW

1.1 Defining retail loans

The term 'retail lending' has different connotations in different contexts. For

instance, Basel Committee on Banking Supervision (BCBS) defines retail exposures

which fulfill the four criteria of orientation, product, granularity and low value of

individual exposures, as laid down in its document titled 'International Convergence

of Capital Measurement and Capital Standards: A Revised Framework'. The RBI

Report on Currency and Finance provides a working definition: 'Retail or household

credit comprises mainly of housing loans, advances to individuals against fixed

deposits, credit card, educational loans and loans for purchase of consumer

durables'. For the purpose of this report, we shall use this definition of retail loans.

1.2 Pattern of growth

Retail lending by banks in India gathered momentum following financial sector

reforms in 1990s. Till then, most of the banking credit was focused on agriculture,

industry, and commerce. The major role of bank lending till then was to support

supply. To ensure that bank lending does not go to finance consumption, the

regulator had put various restrictions on retail credit such as limits on total amount

of housing loan and loans to individuals. Banks could lend only a specified small

percentage of their total lending to individuals for non-productive purposes. The

regulator also imposed strict norms for rate of interest, margin stipulation and

maximum repayment period. These restrictions were gradually relaxed during

1990s which paved the way for increased retail lending by Indian banks.

During the period from 1992-93 to 2005-06, retail loans grew at an average annual

growth rate of 28.4 percent against 19.5 percent growth of overall bank credit

during this period. The annual growth rate of retail loans was greater than the

overall credit growth throughout this period, except in FY 1998-99. It would be

recalled that the year 1997 witnessed the South East Asian Currency Crisis. However,

the annual growth rate of retail loans dipped below the overall credit growth in the

last two financial years, viz 2006-07 and 2007-08. Even in the current financial year

retail loans growth rate is expected to lag behind the overall credit growth rate.

Consequently, the share of retail loans in total bank credit increased from 8.3

percent at end-March 1993 to 22.3 percent at end-March 2007. Chart 1 depicts the

annual growth rates of retail loans and total bank credit during this period on the

left axis as line graphs, and the percentage share of retail loans in the total bank

credit on the right axis as bar graphs.

It is also interesting to look at the share of retail loans in total bank credit in various

bank groups-foreign, private, nationalised and State Bank of India (SBI) group. Chart

2 presents the comparison at three points of time-1996, 2000, and 2007.

The share of housing loans in total bank credit was a dismal 3.2 percent in 1998-

99. But in 2006-07 housing loans constituted 11.8 percent of total bank credit. The

share of housing loans in retail credit first declined from 37.3 percent at end-March

1993 to 27.7 percent by end-March 1998, and then rose sharply to 52.8 percent at

Retail Lending: Balancing Concerns in Difficult Times

end-March 2007. Table 1 depicts the relative growth rates of housing loans and

total bank credit, and the percentage share of housing loans in retail loans during

1993-2007.

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Source: RBI

Chart 1. Trends in Retail Loans Growth

Chart 2. Share of Retail Loans in Total Bank Credit- Bank Group-wise

(End-March)

Source: RBI


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In her keynote address in a conference on 'Retail Banking Directions: Opportunities

& Challenges' in 2005, Shyamala Gopinath, deputy governor, Reserve Bank of India

(RBI), had listed the following four major drivers responsible for the boom in retail

credit market at that time:

1.3 Drivers of growth

1.3.1 Point of view of regulator and bankers

1. Economic prosperity and the consequent increase in purchasing power

2. Changing consumer demographics

3. Technology

4. Declining interest rates

Let us look at each of these drivers in a little more detail.

1. Economic prosperity and the consequent increase in purchasing power

'During the ten years after 1992, India's economy grew at an average rate of 6.8

percent and continues to grow at almost the same rate,' Shyamala Gopinath had

observed in her abovementioned keynote address in 2005. This has given a fillip to

a consumer boom, she had emphasised. This high economic growth resulted in

Table 1. Growth of Housing Loans


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increased job opportunities in urban areas. The reforms had liberalised the

economy paving way for attracting sizeable foreign investment. Job opportunities in

IT and IT-related activities expanded and income levels rose sharply.

In addition to the metros, demand for housing was fuelled by the emergence of a

number of second tier cities as upcoming business centres. Tax incentives for

interest paid and principal repayments towards housing loans brought down the

effective rate of interest.

2. Changing consumer demographics

India has a vast potential for growth in consumption both qualitatively and

quantitatively. It is one of the countries having highest proportion (70 percent) of

the population below 35 years of age. Increasing literacy levels and adaptability to

technology are the two other factors which have helped retail lending to grow.

Another key factor is the emergence of affluent middleclass, which is expected to

grow in numbers further. The present generation of young and affluent working

population in India has shed the paradigm of 'save now, consume later' of the

earlier generations to 'affordable indulgence'.

3. Technology

Technology has played a major role in the growth of retail banking. It has reduced

the cost of transaction, which is a critical factor in dealing with low ticket size of

retail banking. Alternate delivery channels in the form of plastic cards (both credit

and debit), ATMs, Internet and phone banking, and anywhere banking supported by

centralised core banking solution have transformed retail banking experience and

attracted new customers. Technology has also helped in managing the customer

lifecycle, automating and centralising credit origination process, and credit risk

management in retail lending.

4. Declining interest rates

One of the major achievements of controlled pace of economic reforms in India was

managing growth without undue rise in inflation. The inflow of foreign investments,

both direct and indirect, had created ample liquidity. The inflation risk premium

came down resulting in a decline in both nominal and real interest rates, which in

turn, had a positive impact on the demand for retail loans.

1.3.2 Other drivers

Growing disintermediation

Financial sector reforms in the 1990s also created more avenues for corporates to

raise funds. Greater transparency and relaxed controls resulted in deepening and

broadening of domestic equity and bond markets, allowing corporates to raise

funds from these markets at a lower cost.

Big companies were also allowed to raise funds from external markets. As a result,


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the demand for bank credit by the industrial sector slowed down, especially

between 1996-97 and 2001-02, which forced banks to look for alternate avenues of

lending.

Credit risk diversification

At the beginning of the reforms process, banks were burdened with a high

percentage of non-performing assets (NPA) in their commercial and industrial

lending portfolio. Banks looked at retail loans from the point of view of

diversification of their loan portfolio, because in retail loans, the average ticket size

is small and loans are widely distributed over a large number of borrowers. So, the

average risk associated with retail loans is lower than corporate loans. In fact, risk

adjusted return on retail loans is significantly higher than the corporate loans

during normal times.

Information asymmetry

This is perhaps the least talked about driver of retail lending. In retail lending (in

fact, in the entire gamut of retail banking), there is an inherent inequality between

the bank (which is a large organisation), and the customer (who is an individual).

This inequality emerges from information asymmetry, legal resources, and the

capacity to negotiate and withstand losses.

One of the major manifestations of information asymmetry in retail lending is the

standard form contracts and fine print, which hardly any retail customer ever reads

or understands fully. Standard form contracts are not a result of a negotiation

process; they are offered on a take-it-or-leave-it basis; and contain various clauses

in fine print (or in lengthy documents) which mostly operate to the disadvantage of

the customer.

The feedback received in this aspect even from those retail customers who are well-

educated and brilliant professionals; comes as a surprise. Most of them are not able

to fully understand the mechanisms of floating and fixed rates of interest in

housing loans, as specified in the loan documents. For less educated the

mechanism of Equated Monthly Instalments (EMI) serves well to hide the effective

interest rate. Many retail customers do not possess the financial literacy to

differentiate between various products offered by different banks.

Unequal resources

Retail loan customers, being individuals, do not have the same level of resources as

banks possess by virtue of being large organisations. Any action of the bank

ranging from levying of hidden charges, sending unsolicited credit cards, wrong

credit reporting, unlawful activities of recovery agents, and not performing their

side of the contract, cannot be effectively handled by the individual customer,

because he cannot afford to invest time and money required to counter most of

such actions.

The RBI has initiated measures to support retail loan customers, which are detailed

later in this report.


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1.4 Analysis of retail credit growth

Retail loans can be classified based on three main parameters. One obvious

classification is whether the loans are secured or unsecured. In this classification,

housing, auto loans, loan against fixed deposits or any other financial security form

one category, while credit cards, personal loans, and most educational loans fall in

the other category. Another relevant parameter on which retail loans can be

classified is the tenure of the loan. The tenure ranges from 45 days in the case of

a credit card (when there is no roll-over) to over 10 years for housing loans. And

lastly, such loans can be classified on the basis of the social desirability. Housing

loans and education loans for overseas education up to INR 20 lacs (for domestic

education up to INR 10 lacs only) are considered to be priority sector loans.

1.4.1 Housing loans

It comes as no surprise that housing loans constitute roughly half of the

outstanding retail credit in India. These loans are secured by mortgage of

residential property which is quite easy to sell in the market. Up to INR 20 lacs such

loans qualify as priority sector advances, and borrowers who live in these houses

(self-occupied) are interested in retaining ownership, so default rates will be under

control under normal circumstances. For quite a long period the prices of

residential houses kept rising, so there was also no issue of deterioration in value

of the security over time. There has been a prevailing practice of undervaluing the

property for evasion of taxes and stamp duty, under which part of the actual price

paid for the property was paid in cash. The practice was undoubtedly unlawful, and

has been controlled by various administrative steps by the government. But, from

the bankers' point of view it provided another disincentive against default (it has the

effect of increasing effective margin).

Rate of growth of housing loans has been consistently above the overall growth rate

of bank credit since 1997-98 till 2005-06, during which period the share of housing

loans in retail loans also increased from 27.7 percent to 51.6 percent. During this

period, there have been years when the housing loans grew at a rate of 45 percent

and above (the highest growth rate was 73.9 percent in 2003-04). Three factors had

a combined impact on the growth rate of housing loans during this period. These

factors were actual and anticipated movement in prices of houses, effective interest

rates, and the risk weights prescribed by the RBI.

For instance, the risk weights on housing loans extended by banks to individuals

against mortgage of housing properties and investments in mortgage backed

securities (MBS) of housing finance companies, recognised and supervised by

National Housing Bank (NHB) were reduced to 50 percent in May 2002 for capital

adequacy purposes, with a view to improving the flow of credit to the housing

sector. The growth rate of housing loans immediately shot up to 49.5 percent in FY

2002-03 from 29.2 percent in 2001-02. It further increased to 73.9 percent in FY

2003-04. The spurt in housing loans and other retail loans during these two years,

which was also due to decline in interest rates which had come down to as low as

7-7.5 percent for housing and four wheelers, forced the regulator to increase the

risk weight on housing loans to 75 percent and on other retail loans from 100

percent to 125 percent in October 2004.


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During the years of exceptional growth of housing loans, competition intensified,

which in turn, adversely impacted the quality of credit origination. As we shall see

later in this report, this has started reflecting in the rising delinquencies in retail

loans.

1.4.2 Credit cards

Foreign banks in India were the first to start the retail lending revolution in India.

To overcome the restriction imposed by the branch licensing policy of RBI, these

banks began targeting retail customers through other delivery channels. Credit card

was the first product that foreign banks offered to retail customers in India. These

banks operated through franchisees for selling cards, collections, and acting as

customer contact points. Payments of card bills could also be made at courier

service providers' offices, and at own ATMs through cheque drop box mechanism.

Cards were issued for an annual fee, but the major source of revenue was the

commission charged to merchants. It is outside the scope of this report to go into

the operational details of credit card product. To increase revenues from

cardholders, card issuing banks started the practice of part payment of bills (with a

mandatory minimum amount which came down to as low as 5 percent of the

monthly bill amount), allowing cash advances at ATMs (some public sector banks

did it at their branches), and by offering dial-a-draft facility for certain utility bills.

Rolled over bill amounts attracted an astronomical rate of interest (2.5 percent to

3.5 percent per month), which has remained by and large uniform among banks and

across time and has no correlation with prevailing interest rates for other products.

While the credit cards were introduced in the country more than 20 years ago, their

growth in the first six years in this century has been phenomenal. Starting with a

base of 3.7 million in 2000, the number of credit cards issued has grown to 27

million at present. The credit card subscriber base grew at a rate between 25 and

35 percent annually till FY 2006-07. The rapid growth in the subscriber base can be

attributed to the aggressive issuance of credit cards by top 5 players in the industry,

viz ICICI Bank, Citibank, SBI, HDFC, and Standard Chartered. Though a late starter,

ICICI Bank has surpassed the established foreign banks like Citibank and Standard

Chartered by a wide margin. ICICI Bank's credit card subscriber base is around 9

million which accounts for over 30 percent share of the market. A similar growth in

deployment of point-of-sale (POS) terminals at merchant sites also took place during

these six years taking the number of POS to over 3,00,000 about ten times the

number in 2001. ICICI Bank tops the charts here too, with over 1,00,000 POS

terminals followed by HDFC Bank. In a sharp contrast, SBI has chosen to be just the

issuer but not the acquirer-it has not deployed POS terminals. Citibank and Standard

Chartered also have not shown any interest in acquiring transactions by installing

POS terminals. Despite these impressive numbers of growth, the transaction

amount per card has not increased much, as is evident from Table 2, which shows

the data for three years.

1.4.3 Education Loans

Due to the gradual reduction in government subsidies, and proliferation of private

educational institutions for professional courses, higher education has become


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quite costly. Education loans provide financial assistance to deserving students to

enable them to pursue higher education. These loans play a great role in

development of human capital of the country. The real push for educational loans

came from the government in June 2000, when the finance minister underlined the

need for commercial banks to assist poor, but meritorious students for taking up

professional courses. A Study Group under the chairmanship of R J Kamath, then

chairman and managing director of Canara Bank was formed by IBA, to examine the

issue and suggest a model scheme of education loans to be adopted by all

commercial banks. The scheme was formulated by IBA and approved by

Government of India with some modifications. The scheme was advised to banks for

implementation by RBI in 2001. Under the scheme banks were not to insist on any

security for education loans up to INR 4 lacs. In 2004, a further relaxation was made

under which banks were to insist only for third party guarantee for loans up 7.5

lacs, and could ask for a tangible asset as a security only for loans above this

threshold limit.

To make the scheme attractive for banks, these loans were allowed to be classified

as priority sector loans upto limits as detailed earlier in this report. As a result of

these measures, the growth rate of education loans surged to 49 percent in FY

2005-06 before moderating to 25 percent FY 2006-07. State Bank of India has

emerged as the topmost lender in this category accounting for almost 25 percent

of the market share.

Bankers give a mixed feedback on default rates on education loans. Some banks

claim a negligible default rate while others say that tracking students after passing

out is a major risk. To give a further push to education loans, RBI advised banks

that 'under the Basel II framework, educational loans, no longer being a part of

consumer credit, would be treated as a component of the regulatory retail portfolio

and attract a risk weight of 75 per cent, as against 125 per cent at present' in

January 2008. The default rates in education loans are expected to rise as the job

market becomes difficult in the downturn.


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Table 2. Credit card usage


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2. EVOLVING PRACTICES

2.1 The basic model

As already mentioned, foreign banks were the first to start the retail lending in

India. They tried to create origination, collection, and recovery models which were

cost-effective, technology-intensive, and which allowed them to overcome their

weakness of having a limited branch network. They used franchisees or direct

selling agents (DSA) as they were later called, as the initial customer contact point.

These DSAs would sell the products, go to customer and get the application form

filled up, and collect necessary supporting documents. Lending process for retail

loans was centralised and also automated to a large degree using various

origination solutions and credit scoring models. Documentation was again got done

using the DSAs, while disbursements were made either by sending the cheque/draft

by courier. Call centres were set up for interacting with customers, and for

answering their queries and first order handling of grievances. For repayments,

cheque drop boxes were used for credit card bills, while EMIs for housing, personal,

auto, or consumer durable loans were taken via a mechanism of post-dated cheques

(PDC). Electronic Clearing Service (ECS) instructions were also taken in lieu of PDCs.

Follow-up was also outsourced, which was mostly done over phone, followed by

personal visits by recovery agents in case of defaults persisting despite phone calls.

Verification of KYC documents and income proofs were also outsourced.

In this model, the prospective borrower hardly interacted with any bank staff, and

there was no need for him to visit the bank branch, during the entire lifecycle of the

loan or credit card. DSAs were paid a small fee for each sanctioned loan or accepted

credit card application. The bank had to only create a good scoring model, which

would accept or reject the applications based on the data collected by DSAs and

verified by another outsourced agency. Since the selling expenses were borne by

DSAs, it was thought that they would take care and submit only good applications

to improve their profit margins.

When new generation private sector banks, went aggressively for retail loans, or

when SBI went aggressively after credit cards, they largely adopted the model

perfected by foreign banks. Public sector banks were not so aggressive (Chart 2

confirms it) in retail loans, and except for one or two banks these banks largely

followed a branch-centric retail loan approach using own staff for canvassing,

originating, and recovering retail loans.

2.2 How it evolved so far

'So far, the growth of retail credit in India has been largely an urban phenomenon,'

says Yogesh Agarwal, chairman and managing director, IDBI Bank. He is right on the

mark - despite healthy growth rates in retail credit since 1993; most of it was

concentrated in urban areas. How did the banks manage to get these impressive

growth numbers? In a presentation made in September 2004, when retail credit

boom was at its zenith, Chanda Kochhar, joint managing director, ICICI Bank, had

observed that retail credit was at 7-8 percent of GDP even at that time, and that

despite rapid growth in target segments there was still under-penetration of

finance. She had also pointed out that entry of banks in retail credit has led to


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increased competition and coverage, aided by increasing use of technology to

enhance reach and accessibility.

Presenting the core model of retail credit then, Kochhar suggested that sales and

service need to be decentralised while transaction processing and credit monitoring

need to be centralised. This model would lead to economies of scale, and help

separate sales from credit policy and monitoring. The key focus in her presentation

was to look for benchmarks from other industries-manufacturing, retailing, and

hospitality to evolve a model for retail banking.

In practice, this model started showing cracks as growth and competition picked

up. Some of the prominent cracks are highlighted below:

Direct selling agents (DSA)

These were privately set up firms who employed less educated persons at a low

salary. From banks' point of view it was a cost-effective way to sell retail lending

products. Banks did not bother about the business model that these DSA firms had

adopted. Operating on a small fixed fee that they received from banks if their sales

were successful, DSAs and their ill-trained, lowly-paid sales people began indulging

in false promises about the products, finding ways to circumvent banks' credit

policies to increase their success rate, and intruding on the privacy of the customers

as they walked up to the branch or an ATM to transact some other business.

An irate customer of a large private bank had this comment to offer: 'Selling agents

were swarming outside and inside of the bank branch and its ATM centre, and

approaching customers in a manner which reminds one of touts at a railway

station'. 'The only difference is that touts at the railway station do not have

expressed permission of railways whereas these selling agents are acting on behalf

of the bank.'

Predictably, these low-paid sales people changed jobs quite frequently, and used

their contact lists (in some cases, even the photocopies of identity and address

proofs, photographs, and income proofs) in their new jobs with impunity.

Over time, these DSAs became the sole contact point for any prospective customer

for retail loans. Even an existing customer could not approach banks following this

model directly for a retail loan - bank staff had trained itself to deal with prospective

customers via DSAs only.

It is not possible to assess the extent of damage done to customer relationship and

bank reputation by irresponsible behaviour of DSAs, but the issue had caught the

attention of the regulator. Under its guidance, the Indian Banks' Association (IBA)

had formulated a model code of conduct for DSAs which could be adopted by banks

voluntarily.

The code addresses some of the issues which have been brought out, but leaves out

quite a few. But as we shall see later, this problem seems to have been resolved by

market forces.


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Telemarketers from DSAs of different banks were repeatedly calling up the same set

of target customers. The problem of privacy invasion by such telemarketing calls

had reached such a proportion as to necessitate setting up of a no-call-registry.

While these DSAs played a significant role in the growth of retail credit, their

unregulated behaviour caused some structural damages. These were:

� Alienating good customers by intruding on their privacy

� Enticing good borrowers to over leverage

� Suppressing critical information to improve success rate of their sales

� Freely exchanging customer contact lists and private financial data

� Helping non-creditworthy borrowers to circumvent banks' credit policies

Multiple credit cards as debt trap mechanism

The very practice of allowing a credit customer to pay just 5 percent of the total

outstanding every month, which attracts a 3.5 percent monthly interest rate, seems

less of a convenience to the cardholder but more of a strategy to lock him up in a

debt trap. Quite a few credit card customers of an aggressive foreign bank have

expressed a view that their bank appeared to induce customers into a debt trap by

either increasing the card limit or offering another card to customers who were

rolling their card outstanding more or less regularly. In fact, the practice of sending

unsolicited cards, sometimes by the same bank to its existing customer, resulted in

multiple cards with a customer with the aggregate credit limits on all the cards that

he possessed quite high compared to his repayment capacity.

In December 2006, speaking on consumer and service issues in retail banking at

IBA-TFCI 2nd Retail Banking Conference, Kaza Sudhakar, chief general manager,

customer service department, RBI mentioned that his peon had been given cards by

six banks, with a credit limit of INR 25,000 per card. He was categorical in observing

that 'banks are interested in selling retail loans anyhow, even by resorting to false

selling and false promotions'. 'There is a lack of transparency; financially illiterate

customer is unable to make an intelligent choice from the slew of complicated

products being offered by banks,' he had observed.

While the issue of multiple credit cards by different banks to one customer could be

explained by the lack of effective data sharing between banks (we will come to this

when we discuss credit bureau), the practice of issuing multiple credit cards to the

same customer by the same bank defies logic. Why the credit limit on the existing

card could not be enhanced? Clearly, the unsuspecting cardholder was being

induced into drawing funds from one card to pay dues of another, and moving up

in the debt spiral. Competition between various card issuers had brought about a

practice of 'balance transfer' whereby one could transfer outstanding balances on

one bank's credit card to another bank's card. Such balance transfers usually

offered some discount on the rate of interest charged on balances so transferred

only for a limited period of time.

These practices lured cardholders to over leverage themselves. Multiple cards

issued to customers also explain very little growth in annual spends per card

despite phenomenal growth in the number of cards issued (See Table 2). Fierce


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competition also resulted in the income criteria for the issue of new cards getting

reduced, which in turn prepared grounds for eventual defaults.

In addition to almost usurious rates of interest, credit card issuers levied many

charges, which were mostly in the nature of penalties. Some of these penalties were

skewed in favour of the issuers. For instance, the card issuing bank will quietly

authorise a transaction which would exceed the credit limit without making any

reference to the cardholder, but charge the penalty for exceeding the limit. Also the

penalty would be a flat amount which could be greater than the amount by which

the limit was exceeded. Similarly, late payment penalty would be levied for delayed

payments, but no card issuer accepted cash on due date, or gave receipt for

payment received by cheque. Credit card bill payment by cheque was forced to be

dropped in the box only.

Unsecured personal loans

Unsecured personal loans were another mechanism for ever greening of credit card

outstanding. These loans were, usually sanctioned to cardholders with a good

repayment history (includes those who could manage to rotate their outstanding

among multiple cards incurring heavy interest charges). This allowed the trapped

credit card borrowers some discount in interest rates (as compared to credit card

rates) though these rates too were quite high compared to other unsecured loans

like educational loans. Some of these loans were also used by borrowers for

holidays, social commitments, medical expenses etc.

Loans for auto vehicles and other consumer durables

In this category of retail loans, both competition and distributor/manufacturer

discounts kept the interest rates reasonable. Still, the mechanism of Equated

Monthly Instalments (EMI) and the practice of collecting advance EMIs (which some

banks borrowed from non-banking financial companies-NBFCs) did not make the

actual rate of interest transparent enough to be understood by most borrowers.

Stipulations of margin or down payment were reduced sometimes below the safety

percentage. (Some DSAs have reported that an aggressive private bank had

schemes for two wheelers where the down payment was as little as one rupee!)

From the socioeconomic point of view, these loans helped individual borrowers to

acquire necessary modes of transport and consumer durables which improved their

comfort and lifestyle. These loans also helped create the demand for white goods

in the economy, and thereby contributed to growth of the manufacturing sector. On

the flipside, auto loans increased the number of vehicles to such an extent in a

short period as to create traffic snarls and increase in pollution levels on account of

vehicle emissions.

Housing loans

In case of housing loans too, the rates of interest were beaten down to unrealistic

levels. But a software professional, who took a housing loan at a fixed rate of 7.5

percent from a private sector bank laments that there was too much in the fine

print, which was never explained to him at the time of sanctioning the loan. He is


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liable to a much higher rate of interest because of various fine print clauses that the

bank never cared to explain in detail. He also feels that the terms of the reputed

builders and the banks are such that only the borrower suffers in the end. In his

case, the offer of a fixed rate of interest is a classic case of information asymmetry

and standard form contract. If an engineer trained in the topmost engineering

institute of the country fails to fully comprehend the exact nature of the loan

contract he is entering into, can one expect less educated borrowers to understand

what exactly they are contracting?

Rising interest rates have brought such fine print clauses into action, and the rising

EMIs are impacting the ability of the borrowers to pay.

From the banks' point of view, housing loans present a structural problem, because

of their long tenure. Banks can raise only short-term funds, and are exposed to a

greater interest rate and liquidity risk in long tenure loans. So, it is quite natural for

them to incorporate clauses that mitigate this risk. But why did the housing loan

interest rate come down as low as 6-7.5 percent? At this rate, the cost of funds,

transaction costs, and the risk costs cannot be met. Competition for market share

sometimes overshadows prudential business sense-aviation industry too has learnt

it the hard way.

Securitisation and sale

This approach provides an exit mechanism to the bank which had originated the

loan. During the period of high growth of retail loans, a few banks had perfected

this approach to bring down the rate of interest. This is the well-known 'originate

to distribute' model of retail credit, which has been the root cause of subprime

crisis. This model requires a vibrant secondary market for securitised debt. In India,

such a market is yet to reach maturity. Some banks bought housing loan portfolio

because it ranked for priority sector targets, while some bought auto loans portfolio

just to diversify without creating the origination infrastructure.

In early 2006, the RBI issued detailed guidelines on securitisation of standard

assets. Originating banks found the stipulations of capital adequacy and other

norms a bit stifling for the model that they had perfected. Also, the guidelines had

a retrospective applicability to securitisation deals entered into before the issue of

the guidelines. In hindsight, the guidelines did well to keep the 'originate to

distribute' model of retail banking under prudent checks. With unregulated

securitisation becoming a thing of the past, those banks, which were pursuing this

model in a big way, found themselves saddled with a large portfolio of retail

advances before they could put the brakes on the origination machinery. Such

banks now find themselves in both a liquidity crisis and a rising delinquency crisis.

2.3 Recovery approaches

The aggressive retail lending styles described above called for equally aggressive

recovery approaches. In addition to the usual follow up by phone and mail, three

main recovery approaches were employed by aggressive retail banks. These were:

� Post-dated cheques or ECS debit authority


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� Use of Securitisation and Reconstruction of Financial Assets and Enforcement

of Security Interests (Sarfaesi) Act to sell properties

� Recovery agents

Post-dated cheques (PDC)

The basic idea behind taking PDCs is to use the threat of criminal prosecution in

case any of the cheque bounces. The mechanism of PDCs also creates a revenue

opportunity. The bank where the borrower has an account recovers charges for

issuing such a large number of cheques, and also levies penalties if any of the

cheque has to be returned unpaid. The bank which takes these PDCs also levies a

penalty if the cheque is returned unpaid.

Sarfaesi Act

This approach is available only for secured loans, and has been largely used for

housing loans. It has been found to be especially effective against those borrowers

who are living in the residential houses purchased out of loans.

Recovery agents

Aggressive retail lending banks outsourced the recovery and follow up activity also.

Initially used for recovery of credit card dues, the practice was expanded to cover

unsecured personal loans and auto loans later on.

Beginning with a polite reminding phone call that an EMI or card payment was

overdue, the outsourced agencies followed it up with more calls and sending agents

to collect the dues from the doorsteps of the borrower. These agencies were also

entrusted with the job of taking possession of hypothecated assets in case of

persistent defaults by the borrower.

There were some aberrations in this approach of outsourcing the recovery activity

to agencies where defaulters were subjected to intimidation, threats, and in rare

cases, use of brute force. Lack of background checks on their employees by the

outsource service providers, and proper training has been the main cause of such

rare incidents. Courts have imposed exemplary fines on banks holding them

responsible for the acts of their recovery agents resulting in criminal intimidation

of defaulters.

Using the services of recovery agencies is an established international practice in

retail lending. However, in most countries, there is a legally enforceable code of

conduct that these recovery agents have to follow.

2.4 Remedial steps by RBI and IBA

In 1974, IBA had come out with GRACE (Ground Rules and Code of Ethics) for banks

in their dealings with individual customers, says K Unnikrishnan, deputy chief

executive of IBA. These rules kept undergoing revisions till the banking reforms of

1990s, when the liberalisation rendered most of them irrelevant. In their place,

banks came out with citizen charters. In 2000-01, IBA had formulated a model


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citizen charter. In June 2004, IBA came out with 'Fair Practices Code for Banking'.

Unnikrishnan recalls that a review of this code was undertaken by RBI and IBA, which

eventually culminated in 'Code of Bank's Commitment to Customers'.

BCSBI

In accordance with the recommendations of Tarapore Committee, Banking Codes

and Standards Board of India (BCSBI) was set up in February 2006. It was intended

to act as 'an independent and autonomous watchdog to monitor and ensure

that the banking codes and standards adopted by the banks are adhered to in

the true spirit while delivering their services' to retail customers. A twelve-

member working group was constituted by IBA, at the behest of RBI to draft the

'Code of Bank's Commitment to Customers', which was released in July 2006.

The code has been modelled on the lines of similar codes in UK, Canada, Hong

Kong, Singapore and Australia, and addresses the concerns of banks and retail

customers.

While the code does address some of the customer problems detailed above, such

as invasion of privacy, indecent behaviour of collection agents, and the lack of

transparency in disclosing various charges, fees, penalties and mode of charging

interest; it does not cover all.

National do not call (NDNC) registry

The privacy invasion by telemarketers of DSAs and call centres of banks has been

curbed by establishment of NDNC registry by the Telecom Regulatory Authority of

India. The practice is yet to stop completely, but the improvement is visible.

RBI guidelines on credit card operations of banks

In its updated master circular dated July 2, 2007, the RBI sought to regulate the

credit card operations of banks. At the outset, the RBI observes that 'credit card

portfolios of banks mirror the economic environment in which they operate'. 'Very

often, there is a strong correlation between an economic downturn and

deterioration in the quality of such portfolios. The deterioration may become even

more serious if banks have relaxed their credit underwriting criteria and risk

management standards as a result of intense competition in the market.'

These guidelines comprehensively address the issues outlined above in respect of

credit cards and recovery agents. The guidelines prohibit issue of unsolicited cards,

defines what constitutes most important terms and conditions (MITC) which need

to be highlighted, advertised, and sent separately to the prospective customers at

all the stages - marketing, at the time of application, at the acceptance stage, and

in important subsequent communications. Detailed instructions with respect to

wrong billing, debt collection practices, code of conduct of DSAs and recovery

agents, reporting to credit bureau as a defaulter, dispute resolution etc constitute

these guidelines which state that 'the card issuing bank/NBFC would be responsible

as the principal for all acts of omission or commission of their agents (DSAs and

recovery agents).


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RBI guidelines on recovery agents

The din and furore caused by grossly illegal and criminal activities of the recovery

agents employed by some banks (mostly private and foreign) in the media, and very

strict view taken by the courts, forced RBI to issue guidelines to regulate this

practice. In the mid-term review of the Annual Policy for the year 2007-08, the

regulator had noted that 'in view of the rise in the number of disputes and

litigations against banks for engaging recovery agents in the recent past, it is felt

that the adverse publicity would result in serious reputational risk for the banking

sector as a whole. A need has arisen, therefore, to review the policy, practice, and

procedure involved in the engagement of recovery agents by banks in India.' The

first draft of the guidelines was issued in November 2007, and the second draft

which incorporated the feedback of various stakeholders was issued in March 2008.

Under these guidelines, banks have been asked to have a due diligence process in

place for engagement of recovery agents, which would include 'verification of the

antecedents of their employees, through police verification, as a matter of abundant

caution'. Banks have been instructed to inform the borrower about the details of

recovery agents while forwarding default cases to the recovery agents, who should

carry the authorisation letter from the bank along with their identity card.

Conversation of recovery agents with the borrower will have to be recorded. The

methods followed by these recovery agents will have to follow the guidelines issued

by RBI on outsourcing of financial services in November 2006, guidelines on fair

practices code for lenders issued in May 2003, guidelines on credit card operations

as mentioned earlier, and the relevant provisions under BCSBI code pertaining to

collection of dues.

One of the major provisions of these guidelines was to train the recovery agents and

issue them a certification. IBA has tied up with Indian Institute of Banking & Finance

(IIBF) for offering such a course. It is estimated that there are roughly 1,35,000

recovery agents in the country at present. It has been therefore decided that the

banks will be allowed to use the services of uncertified recovery agents till April

2009, after which date only certified recovery agents can be engaged by banks.

Other provisions relate to redressing customer grievances, not inducing these

agents through very stiff targets or high incentives to resort to illegal activities,

increasing use of Lok Adalats for recovery of loans below 10 lacs, and use of credit

counsellors for sympathetic consideration of genuine difficulties of borrowers.


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3. DIFFICULT TIMES

3.1 Growth of retail credit slows down

In FY 2006-07 the growth rate of retail loans dipped below the overall credit growth

rate and has remained below it till now. Though the retail credit growth peaked in

FY 2003-04 to above 50 percent, it was still above 30 percent in FY 2004-05 and

2005-06. Housing loans growth rate moderated to 25.7 percent in FY 2006-07 and

to 12 percent in 2007-08, according to RBI's report 'Macroeconomic and Monetary

Developments 2007-08'. But Housing Development Finance Corporation (HDFC)

reported growth rate in housing finance at 26 percent during these two years,

whereas LIC Housing Finance saw a 41 percent increase in sanctioned loans and a

38 percent rise in disbursed loans in 2007-08.

In FY 2007-08, growth in new credit card accounts was 18 percent, against 33

percent in the previous year. But the growth in credit card receivables has been 86.3

percent between August 2007 and August 2008, which was 49.5 percent between

August 06 and August 07. It is alarming. In fact the exposure of banks to high-risk

unsecured customers, through personal loans and credit card receivables had gone

up from 6 percent in 2004 to 17 percent of total outstanding retail loans in March

2007, according to Credit Rating Information Services of India Limited (CRISIL).

Consumer durable loans rose between August 06 and August 07 at the rate of mere

6.3 percent, and have registered a decline of 7.9 percent in the next year.

Clearly, the mix of retail loan outstanding has shifted towards more unsecured

loans.

3.2 Reasons for slowdown

Rising interest rates

Main cause of the reduction in growth rate of retail credit has been the decrease in

the growth rate of housing loans, which accounts for over 50 percent of total retail

loans. Most bankers attribute the slowdown in housing loans growth to rising

interest rates on one hand and rising property rates on the other. Rise in interest

rates also impacted auto loans to some extent.

Increasing delinquencies

'One who lives by the sword, dies by the sword,' goes the maxim. The retail lending

revolution was led by foreign banks till 2001, but the new generation private sector

banks took the baton from them thereafter (see Chart 2). Some of the private sector

banks had over 65 percent of their total loans portfolio as retail loans. These banks

had to apply brakes in the wake of rising defaults, which in turn, brought down the

retail credit growth of the banking industry.

Fierce competition for market share in retail credit has resulted in asset quality

impairment and over leveraging of retail customers up to 20 times their annual

income during the periods of high growth. This is now manifesting itself as


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increased non-performing loans in retail segment. Many of the retail customers

were first-time borrowers from the organised market, and had no credit history.

The 86.3 percent rise in credit card receivables is a sure sign that delinquencies will

appear in this retail credit sooner or later. A private bank, on conditions of

anonymity, attributes this rise in credit card receivables to the restrictions placed

on recovery agents by the RBI, and recent court judgments.

A report by CRISIL estimates that the proportion of gross NPAs to retail advances

will rise to 4 percent in March 2009, from 2.7 percent in March 2007. A leading

private sector bank has seen a 78 percent increase in the level of its gross NPAs in

its retail loan portfolio in March 2008.

However, Dr K Ramakrishnan, chief executive of IBA says, 'I do not expect defaults

on account of the EMIs going up as a result of interest rate hikes'. The EMIs are

going to go up. 'If there is a genuine problem for a customer because of the bank

increasing the interest rates from time to time which is adding to the increased EMI,

there are instructions in place where the banks have been told to extend the

repayment period so that the EMI remains the same,' he informs.

Inflation control by RBI

Till September 2008, the RBI was concentrating on controlling inflation by

impounding liquidity. In fact, between December 2006 and September 2008, the

RBI increased cash reserve ratio (CRR) by 400 basis points and the estimated

amount of liquidity impounded in the first round due to hikes in the CRR was INR

1,32,250 crores. In fact, a slew of measures to control inflation by controlling

liquidity were initiated by the RBI in the first two quarters of the current financial

year to bring down inflation from the current high levels and stabilise inflationary

expectations.

These measures led to hardening of interest rates, and reduced availability of

lendable funds with banks. A leading private bank which has the largest retail

portfolio in the banking industry was particularly hit with liquidity crunch as its

deposit growth plummeted to 6 percent last year. One of its DSA says that the bank

is not disbursing even the sanctioned housing loans, and that it has completely

stopped two-wheeler loans.

Global financial meltdown

In October 2008, the liquidity in global financial markets became scarce. The

impact of the US crisis spread quickly to Europe and reached India in the form of

liquidity crunch. Suddenly, availability of overseas funds and trade credit dried up.

Indian equity market which had seen the first round of major correction beginning

January 2008 was also not conducive for raising funds.

The second round of correction in equity market came in October 2008. In order to

meet their commitments back home, foreign institutional investors began selling in

Indian equity market, further aggravating the liquidity crunch.


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The RBI had to make the U-turn and reverse the monetary control measures it had

put in place, to ease up the liquidity crunch. It also took steps to soften the interest

rates. In this scenario, for the first time after so many years, banks found that

corporates need bank credit, and are no longer able to negotiate rates below prime

lending rates, since all other avenues for raising funds have dried up. The shift from

retail to wholesale credit has started.

Imminent slowdown

Though Indian banking industry and economy was not directly exposed in a big way

to US subprime crisis, the indirect impact has begun to show. Gems and jewellery,

textiles, carpets, IT and ITES sectors, which were dependent on overseas orders

have been hit by the slump in demand in developed markets. Salaries are being

reduced and jobs are being pruned in these sectors. Fresh graduates are finding it

difficult to get jobs.

In such a scenario, demand for auto, housing, and consumer durable goods is going

down. In any retail loan, an individual discounts his future income stream. In a

slowdown, future income stream becomes uncertain, and leads to reduced demand

for credit. But, to meet his necessary expenditure and to pay the EMIs of loans

contracted earlier, individuals may resort to credit cards.


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4. FINE TUNING THE RETAIL LENDING MODEL

The retail lending model which was imported by foreign banks has been largely

imitated by new generation private sector banks, and a few public sector banks. In

the light of the recent experience in the developed countries, and in India, the

model is seen to be having quite a few weaknesses that need to be addressed.

4.1 Structural deficiencies

Procyclicality

The remarkable growth of retail credit in India during 2000-05, and its quick

slowdown thereafter suggests that the retail lending model that was being followed

was either unsustainable or dependent on high economic growth. It was not

designed to withstand interest shocks, or the slowdown in economic growth rate.

Corporate greed

There is no disputing the fact that commercial banks have to earn profits for their

shareholders. But in doing so, they need to be conscious of their corporate social

responsibilities as well. The aggressive marketing of retail loans, taking some

leaves from the marketing books of hospitality, telecom and consumer goods

industry (as one retail banker had advocated during the boom period) overlooked

one small but crucial difference between retail loans and other retail goods and

services. In all other retail goods and services, the consumer has to part with his

funds - there is an immediate outflow of cash. So, he is able to make a fair judgment

between the value of the goods or services being sold to him against the cash that

he has to part with. But, in case of a retail loan being sold to a customer, it results

in immediate inflow of cash against small regular future cash outflows (EMIs). In this

case, the individual needs to have a greater financial discipline and ability to foresee

his personal financial position over the tenure of the loan.

It is the responsibility of the bank to ensure that its marketing efforts are not

resulting in a retail borrower over leveraging himself. Such over leveraging will hurt

both the borrower and the bank in the long run.

Impersonal relationship

The current retail lending model uses DSAs, call centre executives, and recovery

agents as personal contact points for the customer. For the bank, the retail

customer is just an application or account number. There is no continuity of

relationship. The DSA stops interacting with the customer once the loan gets

disbursed and he collects his commission. For the rest of the tenure of the loan the

borrower interacts with the call centre executives for any help, query, or first level

grievance redressal. If he defaults, he interacts with collection or recovery agents.

All these contacts are with a different person each time. There is hardly a person in

the bank who actually knows the customer, and vice versa.

From the efficiency point of view, this is definitely a good model. Banks have been

able to scale up their delivery capability and reach on one hand and reduce


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transaction costs on the other, using a judicious mix of outsourcing, technology,

and centralised operations. But, it does not allow banks to know the soft

information about the borrower.

Lack of personal relationship and soft information results in the borrower being

treated mechanically by the banks using this model. Such banks have neither the

requisite information nor the willingness to re-phase the loan if the borrower is

facing genuine difficulties.

4.2 Country-specific deficiencies

Lack of financial literacy and credit counselling

Banks while undertaking retail lending in the fashion described above make an

unrealistic presumption that the borrowers to whom they are trying to sell loans,

are capable of 'understanding financial products, concepts and risks, and making

an informed decision about their personal finances'. The reality in Indian context is

quite different. An ill-informed customer is attracted towards well-packaged loan

products without realising the risk attached to them. They are also not well-

equipped to anticipate and manage their personal finances over long-term. Such

customers get into difficulties later, and contribute to NPAs. In developed countries,

financial advisors fill this gap.

Credit counselling is needed by borrowers who find themselves in debt trap. The

RBI has formulated a scheme for credit counselling centres to be established in all

districts of India. Some of the commercial banks have taken up initiatives by setting

up credit counselling centres.

Inadequate dispute resolution mechanisms

The existing model does not provide a convenient and effective mechanism for

dispute resolution at the bank level. Borrowers can either write mails or letters to

the bank (which are replied mostly in automated fashion), or talk to a call centre

executive who has neither the time or the skill and authority to resolve the dispute.

As a result, borrowers either suffer in silence, or approach the regulator or Banking

Ombudsman. In its latest report (2007-08) on Ombudsman Scheme, the RBI has

observed that 'one of the challenges that bank customers continue to face is

ensuring fair treatment from banks. The cases handled by the Banking Ombudsmen

reveal that bankers need to deal with customers in a more transparent manner,

particularly in making them aware of the terms and conditions of sanction and the

specific connotation associated with them right at the beginning. Reasonableness

in pricing of products by banks and their dealing with default situations are other

areas which require added focus'.

It is interesting to note that out of 47,887 complaints received by Banking

Ombudsman in 2007-08, 10,129 were related to credit cards, 757 to housing loans,

5,297 to other loans, 3,740 to charges without notice, and 3,128 to DSAs and

recovery agents.


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Lack of credit history

One of the main requirements of retail credit is sharing of credit information

between lenders. One key issue in India has been the lack of a unique identifier for

each individual for maintaining his credit history. Surrogates like income tax

permanent account number or a combination of available attributes are being used

in its absence.

Though The Credit Information Companies (Regulation) Act came into force only in

May 2005, CIBIL (Credit Information Bureau of India Limited) was established in

2000. Despite the support of the RBI, CIBIL found it difficult initially to get banks to

share their positive file on borrowers. But in absence of any legal force, CIBIL had

to operate only on the principle of reciprocity. Once the RBI grants registration to

other credit information companies, the infrastructure for fair, robust and non-

monopolistic credit reporting will get established.

According to media reports, credit card issuers are now using CIBIL Data to

rationalise the credit limits in these difficult times to control defaults.

5. CONCUSION

Retail banking in India has a great potential because of the low penetration. The

existing model has been evolving with both banks and borrowers learning from

their past experience. The RBI and IBA have tried to create an equitable retail credit

ecosystem in which the interests of both the lenders and borrowers have been

addressed. The recent initiative of granting housing loans at affordable interest

rates by public sector banks demonstrates that retail credit has now become an

important constituent of bank lending.


February 2009

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