Digital lending has got a bad rap, but don’t throw the baby out with the bathwater

With predatory digital lending practices drawing attention, it’s crucial to look at the funding and regulatory environment within which the sector operates.

29 November, 2023
The Print

There have been many reports about the aggressive tactics used by the loan recovery agents of digital lending apps, including harassment not just of borrowers but also of their friends and family. At the same time, there appears to be an industry of ‘scammers’ who defraud digital lending apps by creating fake IDs and digital trails. In navigating these challenges, it is helpful to consider the overall funding and regulatory environment within which the sector operates. It is also important to exercise caution in our quest for consumer protection and not throw the baby out with the bathwater.

A greater perspective can be gained by looking at parallels between the early days of microfinance and the present digital lending scenario. Both emerged to fulfill the unmet credit needs of underserved populations but encountered similar challenges, including the prevalence of predatory lending practices and unintended fallouts of regulatory responses.

The digital lending ecosystem

In the last few years, as internet and smartphone penetration grew, innovation in lending shifted to loans on digital devices. Individuals can now apply for loans with just a few clicks on a digital lending platform. The platform assesses the documents submitted by the applicant and, within a few hours or days, provides a small-ticket loan with a tenure of 3-6 months. Lenders can make quick decisions based on payment and other transactional data on the applicants’ phones. Models of underwriting based on such “alt-data”— drawn from non-traditional sources - enable access to finance to those underserved by the traditional banking system.

The digital lending market was worth $270 billion in 2022 and is expected to reach $350 billion by the end of 2023. Digital loans comprised about 8 per cent of unsecured personal loans in FY23, up from about 5 per cent in FY20. According to the ‘FinTech Lending Trends FY22-23’ report by FACE-Equifax, Tier-3 cities constitute 40 per cent of the market, and 80 per cent of the borrowers are under the age of 40. The average loan amount is about Rs 13,000.

The growth in digital lending has been accompanied by a fair share of complaints, especially against illegal digital lending apps. In response, the Reserve Bank of India constituted a working group on digital lending and, based on its recommendations, established a set of guidelines on digital lending. According to these guidelines, regulated entities (REs) such as banks and non-banking financial companies (NBFCs) can enter into outsourcing relationships with lending apps. However, the responsibility of lending remains with the regulated entity.

The RBI also allowed First Loss Default Guarantee (FLDG) for digital lending fintechs. If a customer defaults on a loan up to a certain threshold of the loan portfolio, the fintech takes the first hit and compensates the lender (bank or NBFC). With this, the RBI ensured that banks did not face the brunt of a potential spike in loan defaults. Last week, the RBI also increased the risk weights for unsecured loans to 125 per cent to “dampen growth in consumer loans”.

Parallels with microfinance

In the early 2000s, we were all fascinated by microfinance. Small-value loans given to women-led groups with joint liability were considered the future of financial inclusion. But even then, there were concerns about predatory lending and coercive loan collection practices. The effective ban on microfinance in Andhra Pradesh in 2010 led to a regulatory overhaul in the sector, with the RBI recognising a new class of regulated entities, namely the NBFC- microfinance institutions (NBFC-MFIs). Despite the lending models being different, there are several parallels between then and now.

First, non-traditional players such as microfinance and digital lending cater to an unmet demand for credit. Accessing banks and formal financial institutions remains cumbersome, and the appeal for more accessible credit is underestimated. By licencing only a limited set of players, we may be pushing multiple sources of credit into the unregulated space. The RBI’s response to the microfinance crisis increased capital requirements to qualify as an NBFC-MFI, leading several smaller and more innovative organisations to fold their operations.

Second, there is a link between the funding of lending organisations and the stress on collection. In the case of MFIs, a substantial amount of capital came from the directed lending portfolios of banks. There were concerns that if multiple MFIs suffered losses on their portfolios, the underlying books of the banks may also take a hit. Digital lending fintech firms, too, are seeing a difficult funding environment, with valuations falling, deals getting delayed, and the higher risk weights imposed by the RBI. The pressure to ensure high repayment rates is huge. The question is whether a tight funding environment upstream can create incentives for loan forgiveness or restructuring at the retail level. This may only be possible when firms are able to charge higher rates for performing assets to compensate for the losses on non-performing ones.

Third, all demands for repayment made by financial firms may not be unreasonable. The premise of credit is that it needs to be repaid. While violence cannot be an appropriate response, other strategies, such as repeated calls, may be an acceptable tool for collection, at least up to a point.

We need better enforcement of ‘acceptable’ methods of credit recovery. It is possible that poor collection practices are largely employed by lenders who have missold credit products to financially unsophisticated borrowers, leading to high delinquencies.

But financial regulation alone cannot solve the problem. Improving financial literacy and empowering people to discern good lenders from the bad will be required to combat unethical sales practices.

Lifting the smog won’t be cheap. India must think finance for cleaner air

Moving to a cleaner environment comes with high costs. As India goes for net-zero emissions, it must include pollution abatement costs in its climate finance strategy.

15 November, 2023
The Print

A noxious fog of air pollution is back in the lives of Indians, or at least those in the Indo-Gangetic belt. We all agree that the toxic air has devastating consequences for our health and well-being and that something must be done. But what has not been acknowledged enough is that the solution requires overhauling the various sources of pollution and that this won’t come cheap. There is a cost that will have to be borne for the transition to a cleaner environment. India has been gearing up to think about climate finance as it transitions to net-zero emissions — the costs of pollution abatement need to be integrated into this strategy. For this to happen, India must take a clear view of the scale of the problem as well as the financial resources it will take to address it.

Big problem, big numbers

Financing the transition to a cleaner environment has to take into account three realities.

First, air pollution is not a Delhi phenomenon. The entire Indo-Gangetic belt is enveloped in smog in the winter months. The extent of the problem is thus much greater than the headlines would have us believe. Second, air pollution is not only about PM2.5. Other pollutants such as PM10, S02, NOx, and CO2 are just as damaging to human health. Any strategy to reduce pollution has to factor in all these pollutants. Finally, pollutants come from many sources— including crop burning, vehicular emissions, road and construction dust, industrial emissions, and coal-fired electricity plants. Each activity emits large amounts of pollutants. It is not useful to focus on just one source while ignoring others. One needs an approach that deals with all of the sources across a large geographical area and includes an estimate of the cost of the transition to cleaner technologies.

Let’s take the example of vehicular pollution. It requires an upgradation of fuel standards and investments in improving public transport. India has adopted Bharat Stage VI emissions standards for all vehicles manufactured after March 2020. The shift to higher standards has cost about Rs 60,000 crore already. Much of this burden will be passed on to customers over a period of time. According to some estimates, diesel car prices are likely to go up by more than Rs 1 lakh with the new standards. There is also a considerable push toward electric vehicles (EVs). The initiative to deploy 10,000 electric buses across cities has cost us Rs 57,613 crore. There are similar costs involved in reducing crop burning by farmers or dealing with construction dust in our cities.

Reducing pollution from power plants would require the installation of emission control technologies and a shift to renewables such as solar and wind energy. Navigating such a transition may not be simple. For example, while the shift to EVs might reduce vehicular emissions in the cities, they might increase carbon emissions near thermal power plants. To decrease emissions from diesel generators, the reliability of power supply must be improved, which, in turn, requires an upgrade of traditional distribution utilities.

Transition finance

India has taken some action to lower air pollution through fiscal measures. In 2020, finance minister Nirmala Sitharaman allocated Rs 4,400 crore for the National Clean Air Programme (NCAP). The plan provides an incentive for cities with a million-plus population to reduce pollution levels by 15 per cent every year. However, this will not be enough. There may be a case for India to access international finance for its air pollution transition, similar to its approach to climate transition. For example, India has integrated green bonds into its climate finance strategy, issuing the first tranche of its first sovereign green bond, worth Rs 8,000 crore in January 2023. Other facilities such as the Global Environment Facility (GEF), the Special Climate Change Fund (SCCF), the Least Developed Countries Fund (LDCF), and the Adaptation Fund (AF) help with the climate transition too. Private sector investment also presents multiple channels toward achieving our climate goals.

It is important to identify areas where there is an intersection between air pollution and climate. For instance, shifting away from coal-fired power plants to renewables, or at least upgrading coal plants, are important elements of India’s net-zero trajectory. But these measures also have a bearing on the air pollution abatement strategy. By considering the synergies between air pollution and climate mitigation, both challenges can be addressed more efficiently.

The air pollution transition plan must encompass the entire spectrum of human and industrial activity. This is not going to be cheap and will disrupt existing structures of production and livelihoods. This is not to say that it must not be done, but careful accounting of the transition costs will help in making feasible plans that will actually deliver over a period of time. The shift toward a low-pollution India will not happen without the necessary financial arrangement.

Pay attention to states’ treasury. If it gets worse salaries and pensions will be affected

Depositors seem to believe that public sector entities will not default. There is a perception that they are guaranteed by their respective state government or ultimately the Union.

01 November, 2023
The Print

Many are of the view that state government debt is not a problem in India. Sure, borrowings are higher than a few years ago, but the bond market is still lending to governments, there is no upheaval in credit ratings, the spread between the Government of India bonds and state government bonds is not large, and the debt to GSDP ratios are not very high. The Union government can always print money, and we don’t have much exposure to international creditors. The problem, however, is that there may be more stress in the fisc of state governments than is visible in the standard metrics. While there may not be a “default” in the traditional sense of the term, there are consequences for the developmental strategy of the state.

Hidden numbers

Take the case of Tamil Nadu. As of FY22, interest payments were 20 per cent of revenue receipts, debt outstanding was 26 per cent of GSDP, and the gross fiscal deficit was 4 per cent of GSDP. These are not scary numbers. But they may not provide the full picture for the following reasons.

First, overall debt does not capture the guarantees the state government has provided on loans taken by other public sector entities in the state. If a loan by a state enterprise goes bad, and the government has guaranteed it, then the repayment of that loan will fall on the state government. Outstanding guarantees in Tamil Nadu increased by 39 per cent between FY20 and FY21. If one were to include guarantees in the debt, then the debt to GSDP ratio would rise to 31 per cent from 26 per cent.

Second, several state governments have off-budget borrowings that do not show on the balance sheets. This implies that the overall debt to GSDP ratio may be higher than what is reflected in the books. Third, many state enterprises have taken on debt that is technically not guaranteed by the government. But if the entity—for example, the electricity distribution utility—were to default, then it is difficult to imagine the state government not coming to their rescue. Staying with the Tamil Nadu example, the total outstanding borrowings of the Tamil Nadu Generation and Distribution Corporation (TANGEDCO) were over Rs 1,45,000 crore in FY22. While this isn’t reflected in the state debt, the possibility of default must play on the state’s mind.

Who is lending to the state?

If there are simmering problems in the financials of a state, how is the state still able to borrow without much repercussions? Why don’t lenders seem to reward the fiscally conservative states and punish the profligate ones? The Indian bond market does not price the credit risk of the state. There is an expectation of a sovereign guarantee—if the state government is not able to pay, the Union will provide support. As a consequence, the probability of default by any state is considered to be close to zero. The bond market is also captive as institutions are mandated to purchase government bonds as part of their investment guidelines. The choice, therefore, is limited and the pricing does not accurately reflect the risk.

Understanding the implications of state borrowing is crucial, especially when considering the unique fiscal constraints of northeastern states that often rely heavily on external support and face significant debt burdens.

State enterprises are able to borrow from financial institutions such as the Power Finance Corporation in the form of loans. The financial institutions are often public sector entities that are funded by either the bond market or through other retail or institutional depositors. It is quite likely that a state financial institution may feel obliged to lend to a state enterprise despite the balance sheet status of the enterprise. Depositors seem to also believe that public sector entities will not default, due to the perception that they are guaranteed by either their respective state government or ultimately the Union.

Impact of a ‘default’

The nature of financial markets in India is such that a default in the traditional sense is unlikely. States will find ways of financing their deficit for a much longer period than they would have in an environment where the bond market is more independent. But as interest payments begin to capture a larger share of revenue receipts, there will be consequences on the developmental expenditure in the state. The revenue expenditure in Tamil Nadu has grown by 9.6 per cent annually over the last decade—but interest payments have grown by 14 per cent. This means that other expenditures, which might benefit citizens more directly, have reduced.

There are other indirect consequences in terms of delayed payments to the private sector—reneging on contracts and increased litigation to postpone inevitable payments which further damages invest-ability and growth prospects that may help the state out of the stressed fiscal situation. Tamil Nadu is just an illustration—there are states in India that will fare worse on these metrics.

If the fiscal situation were to get worse, states may find it difficult to pay salaries and pensions. In the early 2000s, Odisha and West Bengal had reneged on paying their employees and pensioners because they had run into trouble. At the time interest payments in these states were between 30-35 per cent of their revenue receipts, and the debt-GSDP ratios were between 30-40 per cent. While states in India may not be at this precipice yet, they may find themselves there soon in the absence of efforts at course correction.