Moneycontrol Pro Panorama | A costly return journey

Airlines reward round trips more with discounts than one-way journeys because it saves them the cost of pursuing a new customer.

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Airlines reward round trips more with discounts than one-way journeys because it saves them the cost of pursuing a new customer. Do banks do the same with loans? The simple and short answer is yes. This is called credit profiling and assessing the credit risk of the borrower whilst calculating the interest rate that should be charged.

But since this is the return journey of money and not a person, the process is a bit complicated and has many outside players who make the process easy or difficult, depending upon their place. Based on how much and how soon the money lent to the borrower will come back, the bank slaps a premium -- or in rare times a discount -- on the stated loan rates.

We know that bankers have grossly miscalculated credit risk premium in the past. Many a time, they have on purpose turned a blind eye to risk only to find that the return journey of their money is going to be costly for them. At best, they get a small part of the money back and resign to the loss. At worst, they give up and write off.  An outside player is the regulatory ecosystem consisting of the Reserve Bank of India, the government and court of law. The regulator ensures banks behave while the court of law (Insolvency and Bankruptcy Code in this case) ensures banks have a redressal mechanism when faced with errant borrowers.

Since charity begins at home, it is best for banks to learn good behaviour or in other words get the skill and the will to price credit risk properly before they go for redressal. The RBI has put together three draft proposals to make this happen. Rajrishi Singhal, in his column here, details how banks are trying to avoid discipline and running to the government with concerns while the regulator tries to tighten rules. Whether the proposals turn into law or not, there will definitely be a big impact on banking operations over the next few quarters. As such, banks are facing pressure on their net interest margins and profits because deposits are not flowing freely into the banking system while lending is becoming increasingly fraught with stress.

Our Chart of the Day chronicles one such stressed cohort: the microfinance industry. Microfinance lenders are repeating their mistakes, luring in borrowers only to make them overleveraged. Nearly a third of the balances in the loan portfolio of microfinance lenders belongs to overleveraged borrowers with three or more loans. We know this is not going to end well and thankfully, the self-regulatory organisation MFIN has proposed to limit the number of loans per borrower to three from the current four. Analysts at Nomura note that, “We believe the tightened norms will further hamper the growing ability of the MFI lenders as the borrower market size is trimmed down. These guidelines should lead to higher stress in the near term, but should help bring discipline in the sector over the medium term,” Nomura analysts wrote in their note.

The upshot is that it will get a lot worse before it gets better, but lenders must stick to the path.

That brings us to the other facilitator of repayments, the court of law. Though not as efficient as prevention of mispricing risk, at times there is no way other than knocking the doors of the IBC. But the code is falling woefully short in its promise of getting returns for lenders and even in a reasonable time. Dinesh Unnikrishnan, in his piece here, lays bare the shortcomings of the IBC and why banks are between a rock and a hard place in getting back their money.

Be it regulatory or through courts, the return journey of the money lent is becoming costlier and sometimes a one-way ticket to loss for banks. The best course of action for lenders is to avoid temptation of high yields and opt for safer borrowers. Bankers, you have one job! Take the risk but price it shrewdly. Else, you will be stuck with an expensive empty seat in the flight back.

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