By Srinath Sridharan
The mounting concern over the escalating growth of unsecured lending in India has prompted regulatory interventions, with the Reserve Bank of India (RBI) taking notable steps such as raising the risk weights. This apprehension stems from the inadequate attention paid to Asset Liability Management (ALM) within financial institutions, posing the risk of balance sheet disruption and, thereby, threatening systemic threats.
But then, unsecured credit is not inherently detrimental. When managed prudently, it can be as dependable as any other lending form. An excess of singular large risk-exposure is the regulatory worry. A significant number of Indians lack a credit history and operate outside the formal credit access system, rendering lending to them being perceived as risky. Without subjecting these newcomers to credit (potential borrowers) to thorough stress tests assessing their capacity and willingness to repay, lending to them will always be viewed through a lens of suspicion.
For such a large cohort of consumers outside of the formal credit system, access to credit will both be expensive and fraught with the lack of consumer protection. They will either borrow from unregulated sources at atrocious rates or be at the mercy of platforms that offer them loans at usurious rates to average out the large NPAs that some of them have.
In lending, two fundamental questions stand out: How risky is the borrower, and should a loan be granted based on that risk assessment? The responses to these questions not only influence interest rates but also mould future lending practices and lenders’ behaviour with consumers. Regulations play a crucial role in addressing biases, facilitating the discovery of creditworthiness, and maintaining a balance between risk, borrower intent, and risk premiums. This regulatory aspect is vital in shaping a fair and sustainable lending ecosystem.
The idea is to encourage lending entities to offer short-term unsecured loans. The concept advocates a cycle where, upon timely repayment, borrowers become eligible for repetitive lending with risk-adjusted rates. This approach is designed to mitigate initial lending exposure by disbursing smaller amounts. The exposure incrementally grows in tandem with the gradual development of the borrower’s risk profile. This strategy not only promotes financial inclusion, but also ensures a measured approach to lending, aligning exposure with the borrower’s evolving creditworthiness.
India needs a broader range of loan products for diverse demographics and distinct needs. Recognising the importance of predictable borrower income and timely repayments is crucial. For gig workers and those with irregular income, two or three-year loans pose risks. Tailored 30-90 day credit products better suit their needs, aligning repayments with income cycles. The steep costs linked to customer acquisition, underwriting, and collections currently discourage lenders from serving smaller borrowers. Lending community and regulators can test with limited exposure sample size, and determine the optimal exposure tenor that suits the risk profiles as they evolve.
To effectively navigate unsecured lending in India, there is a need to establish a taxonomy that discerns the purpose behind such loans. This classification should distinguish between those sought for livelihood enhancement, akin to an investment in one’s future, and those intended for lifestyle consumption, fulfilling immediate desires. Such categorisation holds the potential to bring a nuanced understanding of the multiplier-effect associated with each loan type.
By doing so, regulators can strategically designate economically-accretive unsecured loans as Priority Sector Loans (PSL), thereby creating a framework for cushioning loans based on their relevance to the broader economic landscape. This approach, rooted in data-driven distinctions, can empower the regulator to address the complexity of unsecured lending, and enable the new-to-credit in entering the formal financial system.
A key benefit for lenders in the current age of digital and finance convergence, lies in accessing previously underutilised datasets. These include both structured and unstructured data, providing a thorough perspective on a borrower’s financial behaviour and creditworthiness. Conventional credit assessment relied on credit bureau information, bank statements, and tax records. Today’s credit bureaus gather a broader spectrum of financial data, encompassing utility bill payments, rent transactions, and even e-commerce activities. This data pool enables lenders to make more informed lending decisions by offering a holistic view of an individual’s financial history.
But it’s the unstructured data that can truly sets the stage for innovation in credit assessment. This category includes social media activity, online behaviour, and text-based data from various sources. Analysing this unstructured data can reveal valuable insights into an applicant’s lifestyle, spending habits, and social connections. For instance, a borrower who consistently shares information about their freelance work or gig economy projects on social media may be a suitable candidate for short-term credit products tailored to their income pattern. Machine learning and AI algorithms have become indispensable tools for sifting through data. These can identify patterns and correlations that human underwriters might miss. For instance, sentiment analysis of social media posts could gauge a borrower’s emotional stability and propensity to meet financial commitments.
To address the regulatory concerns regarding algorithmic lending models, transparency and accountability are paramount. Establishing clear regulatory guidelines for the use of algorithms in lending, including disclosure requirements on data sources and model parameters, can provide regulators with visibility into the decision-making processes. Additionally, implementing regular audits and assessments of these algorithms can ensure ongoing compliance with established standards. A robust framework that prioritises consumer protection, fair lending practices, and systematic risk management can help alleviate the RBI’s discomfort and foster a more confident regulatory environment.
Moreover, the RBI would be concerned about the lasting effects of cultivating a culture of indebtedness, particularly among younger Indians. The accessibility of unsecured credit for diverse lifestyle needs at an early stage might unintentionally foster a pattern of ongoing borrowing, potentially resulting in unsustainable levels of debt. This behaviour could have extensive implications, not only affecting the financial stability of individuals but also casting repercussions on the broader economy. However, it is essential to recognise the necessity of unsecured lending for livelihood purposes, alongside catering to unsecured lending for lifestyle-based consumption. Striking the right balance is crucial to sustain the momentum of economic activity cycles.
The author is a policy researcher and corporate advisor. X handle : @ssmumbai