Credit Constraints

Traditionally, in India, it's been hard to get credit. For individuals or for small companies, when a loan is needed, it has not been easy to obtain. The formal financial system has had a limited outreach, and for most people in the country, the only option consists of going to a loan shark. The loan sharks charge interest rates in excess of 2% per month. Vegetable sellers in Bombay often pay interest rates of the order of 1% per day. Even at these high interest rates, the lender only deals with ``known'' borrowers. Lenders do not easily deal with unknown parties.

The high interest rates charged by loan sharks are not devoid of economic rationale. It is often the case that a person or a small firm wants a loan when it is most vulnerable and the credit risk is highest. The legal system offers little protection or enforcement to the lender. In this situation, high interest rates are not surprising. Many lenders have resorted to strong-arm tactics in collection, and each of us knows horror stories about evil moneylenders exploiting helpless borrowers.

From an economic perspective, this is the problem of ``credit constraints''. In an ideal world, people would be able to borrow or lend in smoothing out year to year fluctuations in income, to produce a smooth consumption stream. In a world with credit constraints, shocks to income get reflected as shocks to consumption. There is a well developed understanding about the pernicious effects of credit constraints on the behaviour of small firms.

In recent years, there has been a lot of interest in ``micro-credit'' initiatives, such as the Grameen Bank in Bangladesh, which uses peer pressure in obtaining a lower default rate amongst individual borrowers undertaking small loans. Grameen Bank charges very high interest rates as compared with those found in the formal sector; however it does play a useful role in giving people a better choice (lower interest rates and an absence of violence) when compared with the loan sharks.

Can we design a world without such harsh credit constraints? Can we design a world where individuals and small firms are able to access credit, at lower interest rates? Remarkably enough, in the last five years, we have seen dramatic change in India in this regard.

High quality collateral. The first area to address is collateral. If a borrower can post good quality collateral with the lender, then the credit risk comes down sharply. Suppose you take a loan by placing a house as collateral. This is not good quality collateral, since the market price of the house is not publicly visible. Suppose we embark on a loan of Rs.1 million using collateral of a house which costs roughly Rs.1 million. Suppose there is a crash in prices on the real estate market, and a few months later the house is worth Rs.0.6 million. The borrower has every incentive to not repay the loan, and leave the lender holding the house. To prevent this, the lender needs to regularly reprice the collateral using market prices. This can't be done on the real estate market owing to its non-transparency.

When the lender revalues the asset and finds the collateral is inadequate, he would ask the borrower to bring forth additional collateral. If the borrower does not comply, the lender would sell off the collateral and close out the loan. Hence, we can now define ``high quality collateral'': assets where the collateral can be repriced daily, and where the lender can sell off the assets easily. With high quality collateral, the lending transaction is driven by systems, and not the subjective (and politicised) evaluation of the borrower.

There is only one kind of high quality collateral in India today: dematerialised shares. It is easy for a lender to obtain stock prices from the NSE, and revalue the collateral daily. If the borrower fails to meet his obligations, it is easy for the lender to sell off the shares at these prices on NSE. When shares have to be sold, there is no risk in settlement owing to the depository.

Dematerialised shares are the first high quality collateral in India's history, accessible to individuals and small firms. Starting from a level near zero as of two years ago, there are now roughly Rs.15,000 crore of loans that are backed by dematerialised shares which have been pledged at NSDL. There are many reasons why individuals and small firms should buy shares, but the ability to use these shares as collateral in order to obtain loans when needed is a new and important reason.

It is useful to reiterate the characteristics of high quality collateral: transparent prices and market liquidity. Even though shares are volatile assets, they are high quality collateral. In contrast, government bonds are less volatile, but they are poor collateral since the market for government bonds is non-transparent.

The Indian banking system has faced serious problems in giving out bad loans. A major focus amongst banks to increase the importance of loans against demat shares would help them improve their health. New initiatives to create a transparent and liquid debt market would convert government bonds into high quality collateral and further enhance the opportunities for loans at low credit risk.

Credit cards. The second new development is the rise of the credit card industry. Millions of credit cards have been issued, and for a large number of individuals, the credit card is the first and simplest vehicle through which short-term credit can be obtained. Most users of credit cards would find it much harder to get a loan from an informal or formal source of credit.

Credit card companies have built up sophisticated information systems, which combine the track record of a borrower with his demographics in order to estimate the risk of default by that person. These information systems and analytical models make it possible for them to do risk management on their credit risk exposures. The typical credit card company is vastly better diversified than the typical loan shark, and can absorb a steady stream of losses.

When individuals do default, credit card companies such as Citibank are reported to have resorted to strong arm tactics in trying to force individuals to make good their obligations, while exercising care to ensure that the thugs are not on the payroll of Citibank itself. It is a failure of the Indian legal system that individuals are unable to protect themselves from such thuggery, just as it is a failure of the Indian legal system that Citibank is unable to collect on these bad debts. This violence is a blemish upon Indian society. However, it is important to note the important achievements of the credit card industry in diminishing the credit constraints that individuals and firms face.

In conclusion. Credit constraints are a significant barrier to economic efficiency and welfare in India. The modern development of liquid and transparent securities markets makes it possible for individuals to easily obtain loans by pledging high quality collateral. The modern development of the credit card industry has brought short-term loans to millions of people who would otherwise have had no credit. These developments are easing credit constraints faced by small firms and individuals in India.

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