Retail Lending

Balancing Concerns in Difficult Times

Author: Hari Misra Editor-in-Chief Finsight Media

Contents
1. RETAIL LENDING UNTIL NOW 2. EVOLVING PRACTICES 3. DIFFICULT TIMES 4. FINE TUNING THE RETAIL LENDING MODEL 5. CONCUSION 3 11 19 22 25

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Retail Lending: Balancing Concerns in Difficult Times

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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 199899. 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
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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.

Chart 1. Trends in Retail Loans Growth

Source: RBI

Chart 2. Share of Retail Loans in Total Bank Credit- Bank Group-wise (End-March)

Source: RBI
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Table 1. Growth of Housing Loans

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. 2. 3. 4. Economic prosperity and the consequent increase in purchasing power Changing consumer demographics Technology 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
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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 welleducated 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

Table 2. Credit card usage

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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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 twelvemember 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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IBA - Finsight Special Report February 2009

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 wellequipped 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 nonmonopolistic 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.

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