Indian Consumer Interest At Bay

Indian Consumer Interest At Bay: There is an ongoing debate in India as to whether the RBI has the legal power to set interest rates. Although the government has the authority to regulate interest rates for banks and others, it is the RBI that decides interest rates for consumer loans and some government loans. Thus, the question is, should the government regulate interest rates for loans in the consumer finance space? If yes, why?

To begin with, regulating interest rates on consumer loans helps to limit the risk that the high cost of credit would be passed on to the customer. In a recent case, the Punjab National Bank (PNB) was found guilty of massive fraud of Rs 13,000 crore in the USD 1,771-crore Nirav Modi fraud case. The bank lost money to a single fraud account with just over Rs 1,100 crore. 

However, it was found that the frauds had gone on for the last six years, due to which the PNB’s books of accounts were inflated (ARC). In an ARC, an Intermediate Financial Institution (IFI) such as the PNB puts in money with another financial institution to purchase assets. Typically, the seller of the asset claims that the cash they have received from the IFI is more than the value of the goods they have sold and presents the difference as an advance. These advances are then lent to the customer. 

However, in the case of the PNB fraud, Nirav Modi was able to generate bogus invoices to siphon off the money from the IFI, where the PNB put in the money.

On the other hand, if the RBI were to decide on interest rates on consumer loans, it would also bear the costs of any mistake is made, thereby raising the interest rate in the future to compensate for any loss. This could, however, result in a loss of confidence in the RBI. 

As shown below, consumer loans are usually cheap, with the result that lenders (banks) will not be able to withstand the cost of a rate hike in the future. If the loans were cheaper, a rate hike would, instead of hurting borrowers, help them to expand.

Source: RBI, RBI data.

Nevertheless, a rate hike is needed. It may be that RBI should lower interest rates first and then raise them later when the excess liquidity in the banking system is brought down, or, the government should be taking up the slack of lower bank rates by taking on more debt.

There is another way. The RBI should allow banks to price the credit risk of a loan differently, based on the product they offer, rather than on the individual borrower. Let us say a bank is offering a loan that offers a 30-day tenure, which, on average, results in an annualized interest rate of 10%. 

If the bank is offering a loan for a period of 100 days, the interest rate on this loan would be 15%. This way, the bank can offer a loan that is cheaper for customers if their borrowing behavior remains the same, unlike a single 30-day term loan that is more expensive, as compared to other types of loans. 

A similar approach should be taken for other loan products, with banks doing away with commissions, which are considered a cost, but result in a loss. In this way, the consumer gets access to cheaper products, while banks pay lower commissions, allowing them to offer customers other products, to which they would otherwise not have access.

Indian banks charge 15% of the principal amount as upfront ‘commission’ on loans, making them prohibitively expensive. However, given the size of corporate lending in India, even if banks charge 15% upfront, the customer should pay almost half of that amount in terms of interest payments to banks. This results in a net loss of about 10% to 20% for the customer, depending on the loan product. This should be made amenable to the customer. 

The theory is simple: by charging upfront interest, banks are protecting themselves from future losses, and the consumer is helped to access other products for which the annualized interest rates are cheaper.

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Disclaimer: views expressed are personal and for discussion only. 

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