The fortune at the bottom of the pyramid can be as elusive as the pot of gold at the end of the rainbow. While consumer goods companies have been struggling to sell profitably to the poor in India, it seems financiers have had an easier time. A host of specialist finance companies now reach out to those who are near-untouchables for the mainstream banks. But lending to customers with poor credit profiles is not as easy as it looks, as some recent news from the US shows.
The Wall Street Journal reported on Thursday that HSBC Holdings PLC has had to take a significant hit on its portfolio of sub-prime mortgages (or housing loans given to the poor). This paper has carried that article on page 20. Others, too, have suffered. One out of every five such loans in the US could end in trouble, according to independent estimates. Two changes in the American economy have led to this bout of trouble. Real-estate prices have declined and interest rates have risen. Home owners have been squeezed in a pincer movement that some economists had earlier warned against. There are also the first stirrings of a political backlash, as legislators there scramble to protect the poor from “predatory” lenders.
Any lessons here for Indian lenders? Over the past five years, many big foreign banks rushed into the business of high-risk loans. They have either sought out more risky borrowers or given loans without collateral. They have done this through their finance company subsidiaries. GE Money, too, has been an active pioneer.
The attraction is obvious: Lending to sub-prime customers is risky and lenders can charge higher interest rates to compensate for the higher risk. Most of these loans are unsecured—so the pain from a default is higher. The profits on each loan can be as high as 12-15%, many times more than the wafer-thin spreads earned on regular loans.
But the risk of default is higher, too. The trick is to manage risks. The foreign banks have invested heavily in back-end information and risk management systems to ensure that they spot any hidden dynamites in the loan books of their subprime subsidiaries. But the best risk-management systems can be of little use if the economic tides move against you.
Sub-prime lending should be recognized for what it is: a very risky game. The real issue is: Who should control the risks—the lenders or their regulator? It would be better if the lenders discipline themselves, rather than attract the attention of the regulators and interventionist legislators.
It is sometimes argued that foreign banks in India have been pushed into risky lending because of tight restrictions on them. They cannot open branches with the same freedom as Indian banks can, and hence have used finance company subsidiaries to grow their business in India.
This is not quite true. Subprime lending is part of the core strategy of many foreign banks in Asia, which is why this business is growing rapidly even in relatively more open banking markets such as Singapore and Hong Kong. The very fact that there are problems in the US shows that the rapid spread of sub-prime lending has nothing to do with branch restrictions.
Indian banks have not gone down this route because the Reserve Bank of India has kept a tight watch on them. They are not allowed to open finance companies to do unsecured lending. Some banks tried to skip around these regulations by lending to domestic finance companies. The central bank has rapped a few knuckles to discipline the truants.
There are huge swathes of the economy that need funding. Finance companies service this market because banks refuse to do so (or are not allowed to). Sub-prime lenders are not little devils with horns, who are incapable of doing any good. They do perform a useful function. The success of several domestic truck-finance companies show that they can profitably lend to individuals and organizations that would otherwise find their growth ambitions capped by the lack of funds.
So, let’s not throw out the baby with the bathwater.
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