Setting up the ecosystem for personal credit

by Renuka Sane.

Why should we take interest in individual credit?

When we think of a credit market, we generally think of borrowing by large firms. But individuals, like you and me, are also important participants in credit markets. Some of us are entrepreneurs - we dream of new ventures, and in the process create new goods and services. As entrepreneurs, we often start out as sole proprietors, limited by the equity financing we can muster. In all countries, credit to individuals is a mechanism for small business financing.

In addition, borrowing is done by individuals in order to shift consumption through time. This is called consumption smoothing. This is especially important for low-income households whose incomes are reliant on seasonal cycles such as agricultural harvest, but whose consumption patterns require liquidity over the entire year. Alternatively, when poor people are faced with shocks like illnesses, borrowing helps improve the stability of consumption.

In short, the objective of a well functioning market for personal credit is that it should support entrepreneurship by individuals and consumption smoothing.

The importance of credit for individuals is reflected in the emphasis that programs such as Startup America, and the Entrepreneurship 2020 Action Plan, EU are placing on accessing capital. The importance of credit is also seen in the growth of micro-finance in economies in South Asia and Latin America, which cater to the demand for credit from low-income consumers.

How well are we doing in India today?

Financial exclusion

The CMIE household survey data shows that only 14% of households had credit outstanding in March 2014. This highlights the failure of decades of policies that have attempted to obtain financial inclusion through heavy-handed State interventions. The lack of availability of adequate and timely credit is the biggest problem affecting the growth of the small scale enterprises in India (Banerjee and Duflo, 2014). Financially excluded households lack the ability to smooth consumption. This induces welfare loss. It also gives them extreme incentives to seek out informal credit at outlandish prices as the marginal utility of consumption smoothing is extremely high.

Concerns about consumer protection

Many loan products involve unfair terms that customers do not understand, or interest rates that are so shrouded, that customers are not able to rationally evaluate the expected repayments. There have been several complaints regarding such practices by banks as well as informal sector lenders. Such mis-selling makes consumers wary of transacting, and lays the political foundations for extreme government interference (Sane and Thomas, 2015).

Emphasis on secured credit

The bulk of personal loans outstanding are housing, vehicle, consumer durable and education loans - all of which are collateralised. The credit market in India only delivers capital to those who have assets to pledge. This is true of SME loans as well. This constrains entrepreneurship, especially in service, technology and knowledge industries which require a system that lends based on an assessment of future cash-flows, and not on the basis of existing collateral.

Lack of sound arrangements when faced with default

All over the world, orderly systems have been setup to cope with consumer default. In India, some creditors have resorted to coercive collection practices. Incidents in the early 2000s led RBI to issue a circular on Guidelines on Fair Practices Code for Lenders, May 2003 that directed lenders to not resort to undue harassment for loan recovery. Anecdotes suggest that the practice is not fully controlled. The micro-finance crisis in Andhra Pradesh in 2010 also had its roots in coercive collection practices. Even if strong arm tactics are not used, a person with unpaid loans has no way of cleaning the slate and starting over. Legal proceedings are known to linger on for decades.

Loan waiver programs

India has a long history of loan waiver programs. Sensational stories about poor people burdened under large amounts of debt from evil lenders gain traction in the political discourse. The largest of these was a Rs.760 billion farm debt waiver in 2008. The adverse effects of such a waiver include the destruction of the loan repayment culture and a rise in strategic defaults. For example, Gine and Kanz (2014) find that moral hazard in loan repayment intensified after the 2008 program. The threat of future loan waiver programs by the government makes banks complacent and reduces the credit culture among borrowers.

Diagnosing the problem

The first problem in the personal credit ecosystem is the lack of consumer protection that can safeguard against mis-selling at the time of the sale of the loan, coercive recovery practices, etc.

The second problem is the absence of well-functioning insolvency framework for enforcing repayment of loans. It is the job of insolvency laws to ensure that creditors can seek remedy of the courts to force the debtor to restructure the loan, or to liquidate assets to pay off the creditors. The presence of such laws, and smooth institutional mechanisms which enforce these laws, makes creditors more willing to lend. The laws also ensure that debtors can also seek remedy from immediate collection actions of creditors, and buy time to reorganise their finances, or sell assets, at the end of which they can get a "fresh start". This makes them open to taking more risks. The design of institutions in personal bankruptcy shapes the functioning of credit markets (White, 2005). This is why, for example, bankruptcy procedures and a second chance for honest entrepreneurs is core to the Entrepreneurship 2020 Action Plan in the EU described earlier.

The way forward

Building a sound market for individual credit requires a two-pronged approach. One part is enacting the draft Indian Financial Code, which sets up a sound regulatory framework for financial firms and ensures consumer protection. The second part is the draft Insolvency and Bankruptcy Code, which sets up the machinery for dealing with default.

The draft Insolvency and Bankruptcy Code has four core features:

• It proposes an Insolvency Resolution Process (IRP) in which creditors and debtors can re-negotiate the repayment of loans. This offers debtors relief from collection action of creditors, while offering creditors a chance to collect their dues over time. This would be particularly important for personal insolvency which is really the insolvency of a proprietership.
• The Bill also proposes a bankruptcy process in case the negotiations fail - this implies the sale of personal assets to repay creditors.
• For low-income households with small loans, the Bill proposes a Fresh Start mechanism, whereby a debtor can seek to waive off his debts. This brings an element of predictability in the way loan-waivers take place in the country, distributing them through time as a large number of small transactions, and shifting the burden from the taxpayer to the shareholders of banks. Moral hazard is contained by flagging the person as a defaulter, for life, through credit bureaus.
• No matter what trajectory is followed, the set of steps that are followed after default by a person are specified clearly, these steps play out in modest periods of time, and end with the case being disposed of. This is in contrast with the present arrangements where a default turns into a legal problem for decades.

The draft Bill thus balances two objectives: on one hand, it provides debtors some relief through the discharge of some of their debt, and on the other, it seeks to improve credit availability by enforcing repayment.

Rolling out the consumer protection framework proposed in the IFC and the individual insolvency framework proposed in the IBC will lay the foundations for a healthy market for individual credit.

References

Banerjee and Duflo (2014), Do Firms Want to Borrow More? Testing Credit Constraints Using a Directed Lending Program, Review of Economic Studies, 81(2): 572-607

Gine, Xavier and Kanz, Martin (2014), The Economic Effects of a Borrower Bailout: Evidence from an Emerging Market, World Bank Policy Research Working Paper No. 7109.

Sane, Renuka and Thomas, Susan (2015, forthcoming), "The real cost of credit constraints: Evidence from micro-finance", The B.E. Journal of Economic Analysis and Policy.

White (2005), Economic Analysis of Corporate and Personal Bankruptcy Law, NBER working paper 11536, July 2005. Published as "Bankruptcy Law," in Handbook of Law and Economics, edited by A.M. Polinsky and Steven Shavell. Elsevier.