Banks’ home loan portfolios set to feel the stress. RBI must devise measures

The economy is facing a rising interest rate cycle for the first time in several decades. This is likely to pinch the retail loan segment.

23 August, 2023
The Print

Many of us may have heard of a regime of “rising interest rates” in the last few months. Those of us with home loans may also have seen that the duration of our loans has increased — instead of asking us to pay higher EMIs, banks have increased the number of months for which the loan will continue. On 18 August, the RBI came out with a circular that asks banks and NBFCs to provide the option to the borrowers to switch over to a fixed rate as per their Board approved policy. The circular also says that banks and NBFCs should ensure that elongation of tenor in case of floating rate loan does not result in negative amortisation. These changes have to be implemented by 31 December 2023. The policy says a lot on what the RBI is worried about, and what it might mean for retail credit market. The RBI may need to devise measures to deal with an increase in stress on the home loan portfolio of banks, as well as worry about consumer protection issues in the credit space.

Loan book and interest rates

We are facing a rising interest rate cycle for the first time in several decades. Banks are preferring to increase the overall tenor of the loan instead of the EMI as it is easier on the individual. But the term of the loan for many borrowers may go beyond the age of 60, or despite paying the monthly instalments, borrowers may find the amount owed to the bank going up because the existing EMI is not enough to cover the interest. The RBI in its circular has asked banks to make sure that the elongation of the tenor doesn’t lead to this situation. This implies that banks will have to increase the EMI. This may mean that the stress on many homeowners increases, and that some of these may go bad in the coming years.

Over the last decade, the lending portfolio of banks has shifted to retail loans. In FY2013, share of industry in total banking credit was 42 per cent. By FY2023, it had dropped to 25 per cent. The retail book (consisting of personal loans) on the other hand, has grown. It stands at 28 per cent of total banking credit. There is, in fact, an almost exact reversal between industrial loans and consumer loans in incremental bank credit in this period. The top category in personal loans is that of home loans, at 14 per cent, followed by vehicle loans at 3 per cent. While bank profitability has risen, and it seems that the period of non-performing assets (NPAs) is behind us, there are concerns about the rise in NPAs on these new retail loans. There is an expectation that gross NPAs for the micro, small and medium industries will rise by 10-11 per cent next year. There may also be impending stress on home loans. The last decade of the banking sector has seen loans going bad, ever greening of loans, limited success of restructuring schemes and eventual write-offs. It is important to not repeat the mistakes of the past, and confront the bad news through adequate provisioning, and capital enhancements should it come to that.

Floating vs fixed: Can the customer choose?

Banks give home loans over a 15-25 year horizon. Lots can change in this time period. The world can go from a time of peace to a period of war. Economies can go through a boom and bust cycle. A floating interest rate allows banks to price loans such they charge a lower interest rate when times are good, and increase rates when times go bad. Since this flexibility is not there in the case of fixed interest rates, they are usually higher than the floating interest. Even if banks were to provide the option to go back to a fixed interest rate from next January, these are likely to be higher than the floating interest ones.

The larger question is, whether there is a meaningful way in which consumers can make an informed decision on whether to choose a fixed or floating interest rate at the time of taking a loan, and later in the cycle of the loan, if the option is given. This brings us to the complex question of consumer protection in finance, and in credit markets in particular. It is difficult to envisage the future of interest rates, evaluate the impact that a floating interest rate may have on one’s finances in the next decade, and decide if it makes sense to go for the higher fixed interest rate today. One can make consumers aware of the risks of a floating exchange rate regime, but choosing the best option is an advisory function that banks may either not be incentivised to play, or be reluctant to play. A third-party financial advisory market that works in the interest of consumers has not developed in India. This leaves the RBI in a situation where it may not be able to do much more in helping consumers make the correct decision for themselves.

India’s gig workers need urgent social security. But Gehlot’s new law isn’t the answer

India's experience with Coal Mines Provident Fund and Seamen's Provident Fund should lead us to ask if the idea of a centralised welfare fund is itself problematic, and prone to misuse.

09 August 2023
The Print

A new phenomenon of the gig economy is upon us. This is a particularly important development in India, which is staring at low labour force participation. The clamour for intervention in the gig market has also begun. For example, the Rajasthan government recently passed a legislation that provides social security to gig workers. There is also a Code on Social Security 2020 at the Union level on the cards.

Social security sounds like a good idea, but when not done right, there is a real danger that it will be lost in the administrative problems of a poorly managed and governed welfare fund. For several gig workers, the existence of platforms provides an income, relative to not being in the labour force. We should not lose sight of these pressures in our attempt to provide security to specific types of jobs. Instead, the focus should be on designing mechanisms that are effective and sustainable.

A welfare fund

A “welfare fund” is often at the heart of many social security initiatives in India, including the Rajasthan fund, which is to be run by gig workers, government, and industry representatives. The fund will be financed through a cess on platforms as well as contributions by workers. A contributory fund of this kind requires financial expertise as well as governance mechanisms. Collecting contributions is of little use if financial markets are not harnessed to gain from the power of investments and compounding. Similarly, without iron-clad governance mechanisms, a fund runs the risk of becoming another pot of money to dole out to favoured participants.

It is useful to ask how well has the model of such a fund worked in the past? The Coal Mines Provident Fund, and the Seamen’s Provident Fund are examples of similar attempts at providing old-age security to fund members. And yet, we find that there have been several irregularities. A CAG report in 2021 found that the indecisiveness of the Coal Mines Provident Fund Organisation on certain debentures caused a loss of almost Rs 300 crore. More than twenty years ago, the Seamen’s Provident Fund Organisation lost almost Rs 100 crore because of irregularities in trading of securities. Accumulations at the end of one’s working life do not translate into a monthly pension without a draw-down plan. This experience should lead us to ask if the idea of a centralised welfare fund is itself problematic, and prone to misuse given its proximity to politics.

How do we provide social security then?

The gig workers bill also raises questions on what we should reasonably expect from an employer, or in this case, the provider of a “job”. Traditionally, social security was tied to employment. The new world of labour mobility and the gig economy have changed this equation. It is also important to note that when social security is tied to an employer, the cost of it is inevitably borne by the employee. What may look like an employer contribution is eventually the total compensation to the employee divided into various components.

While social security can include many pieces, two elements – life and accident insurance, and pensions – are particularly amenable to a different design. One of the causes of hardship is the death or accident of the breadwinner of the family. This is best solved through the purchase of term insurance from a professionally managed insurance firm, rather than through a welfare fund. Group representatives can potentially negotiate with a life insurance firm for better rates and more efficient claims processes. The insurance firm is a regulated entity and more equipped to price the insurance correctly. As well, the bouquet of products through the Jan Dhan scheme had promised some life and accident cover. Why not harness them instead of devising new contracts to do the same thing?

Old-age income security also consists of saving during work life and drawing-down that wealth after an exit from the labour force. The collection of low-valued contributions and their investments need to be facilitated through low-cost fund management. Only this can ensure some build-up of wealth for retirement. It is infeasible for a welfare fund to provide any pensions unless the welfare fund itself outsources the task to a professionally run fund management entity.

A feasible strategy

A more sensible strategy for gig workers would have been to find ways to leverage existing schemes to obtain insurance and savings for old age. This holds true for the discussion at the Union level as well.

Critical aspects of record-keeping and fund management have been resolved in some of these schemes such as the National Pension System or the Atal Pension Yojana.

One could devise mechanisms such that some of the payments to the worker get directly deposited in their pension account or towards their insurance premiums, and for that pension or insurance account to move with the worker as she moves around to different gigs.

The administration of these systems rests with professionals equipped to manage the complexity of these financial products. The choice of contribution should rest with the individual.

Low-valued transactions are often more expensive to carry out, and it is here that fiscal transfers by the State may have more impact. Workers can also be incentivised to save in pension assets through co-contributions by the State.

The government also provides a means-tested cash transfer to the destitute elderly through “social pensions”. There is a need to focus on such cash transfer programmes to provide a floor on consumption. The current approach of social security for gig workers for both insurance and pensions is unlikely to yield benefits.