‘Buy Now, Pay Later’: What is it, and how does it affect customer protection?
Author:
Dwijaraj Bhattacharya
In our previous post, we discussed how the RBI’s Resolution Framework 2.0[1], which is one of the key policy interventions to combat debt distress induced by COVID-19, needs to be amended and extended beyond its current termination date of 30th September 2021. In this post, to help enhance the efficacy of such frameworks, we lay out the key principles that the two primary actors, the banking sector regulator and the regulated lenders, must be guided by while designing policies to tackle debt distress caused by severe economic shocks. In Part 1 of the post, we focus on the four broad principles that the regulator must follow. In Part 2, we discuss another four key principles for the lenders to follow.
Part-1: Principles for the Regulator
1. Continuity and Clarity of Regulation: Though all economic shocks are unique, there are often similarities in their progression. The first phase in their progression is the occurrence of the shock. In most cases, the occurrence of such shock events tends to be sudden, while their impact is long drawn. Thus, the policy tool to tackle the three emergent paradigms (of shock, stabilisation, and recovery) must be different for each paradigm. The International Monetary Fund (IMF)’s note on “Private Debt Resolution Measures in the Wake of the Pandemic” lists these three phases of policy response as: “Freeze, Transition, and Fighting the Overhang”[2].
Phase One – Freeze: This phase corresponds to the initial set of measures that a regulator must adopt to provide immediate, but temporary relief during the period where economic disruptions are rampant. In the context of the pandemic and India, this phase would correspond to providing a moratorium on debt, utility payments, etc.
Phase Two – Transition: Since, in the aftermath of a shock event, economicactivity is likely to take time before it can reach the pre-shock levels, this period is characterised by a typical borrower being able to repay, but not completely. Depending on the nature of the shock, and the impact on the economic activity, the period is likely to differ and can extend into years. Thus, the regulator must design policies that enable and incentivise restructuring or reorganisation of debt.
Phase Three – Fighting Debt Overhang: After the shock event has passed and economic recovery is complete, it is expected that the temporary measures discussed in Phases 1 and 2 would lapse. Thereafter, all cases of debt distress should be treated using traditional mechanisms that exist during the “normal course of business”. Such mechanisms will include the insolvency and bankruptcy regimes under which the borrower may seek refuge.
Currently, India is undergoing the second phase, i.e., the transition phase, since the two deadly waves of the pandemic have passed, and economic recovery is underway. However, it must be noted that the remedies suggested in the third phase are presently non-operational for natural persons and non-corporate businesses, which form the bulk of micro, small and medium enterprises in the country. Thus, for India, there is a dual need to ensure robust policies to navigate the current transition phase and to notify appropriate policies for the third phase.
Further, in addition to the continuity of regulations, the regulations must be designed and conveyed to all stakeholders with utmost clarity. Often, in times of crisis, the regulators, like many other authorities, have to scramble to manage the situation and its likely fall-out. Therefore, it is feasible that the level of clarity of regulations is diminished. For example, under both the Resolution Framework 1.0 and 2.0, it is unclear whether lenders are free to offer restructuring to borrowers from the allied agricultural sector[3]. This lack of clarity, in turn, impacts the lenders’ choices, thus impacting the economy. Therefore, it is pivotal not only to have continuity of the regulation, but also clarity in communicating the same to the regulated entities and general public.
2. Temporal Convergence: While designing remedies under each of the phases, the primary consideration that must be accounted for is the event that precipitated the need for such a remedy. The duration of the disruption and the time needed for recovery will be different depending on the nature of the event that caused the disruptions. To exemplify, if a moratorium is announced in the aftermath of an earthquake or a cyclone, the time needed to make recovery is shorter, compared to a pandemic, where the rate of infection generally tends to rise after a decline. The second wave of the pandemic serves as an unfortunate example of the phenomenon.
While, on one hand, the nature of the event determines the required duration of each policy intervention, on the other, the soundness of the financial system, and its capacity to absorb short-term liquidity stress, indicate a feasible duration for such remedies. To take the example of the moratorium, a financial system where it is easier to provide a moratorium on the lenders’ liabilities is more likely to withstand a longer-term repayment holiday for customers, since in the absence of a moratorium on lenders’ liabilities, severe asset-liability mismatch may occur when the repayment requirements on its customers are suspended.
Thus, to ensure adequate coverage of the target population, the policies need to have a timeline commensurate with the impact period of the shock event, both in terms of the immediate disruption caused by the shock and the recovery in its aftermath. In the case of the current pandemic, with the possibility of a third wave of the disease looming, it is ill-advised to discontinue any restructuring window. Instead, restructuring windows should remain functional till the economic recovery is completed. However, that may exacerbate the costs associated with the remedy, which the regulator must distribute equitably amongst all participants.
3. Equitable Cost Distribution: Another key consideration that emerges is who must bear the cost of any remedy that combats debt distress. In India, immediately following the pandemic, a moratorium was declared. However, initially, lenders were free to charge compound interest to their borrowers[4], whereby they could transmit the entire cost of the remedy and the economic shock to the customer. Later the Union Government of India came to the aid of the borrowers and covered the cost of additional “interest on interest”[5], leading to a cost distribution mechanism, where the cost of the remedy got distributed amongst a plurality of actors, i.e., the state and the customers.
Though such an intervention was necessary, the scope for greater cost absorption by the state in a country like India is limited. Given the inadequate fiscal headroom for the state to absorb all additional costs, a cost-sharing mechanism must be devised. Such a mechanism must not rely on fiscal support, but distribute the cost between borrowers, lenders, debt investors and shareholders. For instance, the regulator could consider requiring higher risk weighting for the restructured book or higher provisioning during the near term till the effects of the pandemic have subsided, as has been done in RBI’s Resolution Framework 2.0[6]. Such measures would help to ensure that lenders who opt for restructuring do so prudently.
In India, an NBFC is currently allowed to offer a restructuring window to its customers. However, the creditors of the NBFC are not required or incentivised to offer either a moratorium to the NBFC or restructure its debts[7]. Such situations lead to a disproportionate cost distribution of the remedy, where downstream lenders like NBFCs are forced to keep servicing their own debt (often from banks) despite dwindling cashflows, threatening their solvency. This, in turn, disincentivises NBFCs from offering remedies designed to target debt distress. It is, therefore, imperative that adequate regulations be created to ensure that the cost of any remedy is not passed to a single member but is borne equitably by all participants in the credit ecosystem.
4. Incentive Alignment: As discussed in the earlier principle, the lack of cost-sharing impetus may distort the incentives of the lenders to offer remedies to their borrowers. However, once such cost-sharing mechanisms are notified, misalignment of incentives may persist. The first misalignment occurs when lenders are not adequately incentivised to offer restructuring or other remedies to their borrowers. Often, lenders may believe that the impact of not offering a remedy is positive for their balance sheet.
Taking the case of microfinance loans, where traditionally over-indebtedness has been a known phenomenon, despite which collection efficiencies have continued to be good for the most part[8], a lender may expect the borrower to continue repaying despite hardships. Thus, the regulator must incentivise all lenders to offer remedies like restructuring to combat the widespread debt distress in the wake of the pandemic. Such incentives may vary, ranging from having to report the number of applicants for the restructuring and the number of applicants served to designing targets for outreach and communication, and to providing regulatory forbearance against restructured loans.
While the “carrot” will ensure providers offer the remedies to a majority of deserving customers, there must be a corresponding “stick” to prevent moral hazard. Lenders can misuse the restructuring window and restructure substandard assets to free capital. Thus, the regulator must ensure that adequate punitive mechanisms and robust supervisory processes are put in place to mitigate concerns of moral hazard.
Finally, apart from the aforementioned principles, a self-explanatory consideration that must go into the design of any policy to tackle debt distress is the economic position of the customers. However, when moratoria or restructuring windows are declared by the regulator through the use of rigid guidelines, it can easily become counter-productive for the targeted borrowers. This is because the banking sector regulator is often at a distance from the borrowers, and therefore is not well-positioned to adjudicate customer needs. Although the regulator has an overview of the aggregate customer profile, lenders are better suited to understand the financial position and the needs of their individual customers. Thus, any decision on the design of a moratorium or restructuring window that creates rigid eligibility requirements, without much flexibility afforded to the lenders, may end up harming the customers rather than protecting them. The regulator, in turn, should therefore provide guidelines to enable lenders to make better decisions regarding such remedy. In case of restructuring, the regulator should lay out in detail the following principles (and not granular prescriptions) for the lenders to follow.
Part-2: Principles for the Lenders
1. Assessment of the Economic Sectors: The impact of the pandemic has been different for different sectors. The RBI, cognizant of the phenomenon, had set up the Kamath committee to identify the sectors where stress has been severe. Natural persons and small businesses from such sectors will likely be worse off and face more distress than their counterparts from others. To elucidate, we can take the examples of the agricultural and the allied sectors, which were designated as essential and were allowed to continue during the pandemic, and contrast it with sectors like hospitality and tourism, which essentially did not see any economic activity. Thus, the impact of the crisis on individuals working in the hospitality and tourism sector is likely to be more than the impact on individuals engaged in the agricultural sector.
Thus, at the primary level, it is important to not only categorise accounts in terms of the type of account, i.e., personal loan, or credit card, but to also look at the underlying economic sector where the individual or her family is employed, or where the business operates. Thus, lenders are advised to account for the impact of the pandemic on the economic sector and its expected recovery trajectory while deciding on the eligibility of the borrower for any restructuring. The RBI’s Kamath Committee (2020), for example, acknowledges that “Impact [of COVID-19] is pervasive across several sectors but with varying severity – mild, moderate and severe”[9]. In turn, the committee also proposes that “simplified restructuring for mild and moderate stress”[10], whereas, severe stress cases “would require comprehensive restructuring”.[11]
2. Assessment of the Geography: In India, the caseload for the disease is widely varying, which, in turn, has caused differential regulations for economic activity. While certain economic activities are allowed in certain states, they are prohibited in others. Therefore, it is not only important to take into account the economic sector of the applicant, but also the geography where she resides ascertaining eligibility for remedy.
3. Templatisation of Restructuring Decision: Every individual will have unique characteristics regarding the economic sector they are employed in and the geography where they live. However, it is impractical for the lender to offer infinitely customizable solutions to their borrowers primarily because such customization will be cost-intensive. Therefore, it is proposed that the lenders templatise the decision making.
The RBI’s Kamath Committee (2020) performed a similar task of identifying “suitable financial parameters that should be factored into…resolution plans”. [12] However, in the case of natural persons, the situation is expected to be more diverse. Further, it would be a folly to equate a natural person with a corporate one. Therefore, it is proposed that a broad decision-making matrix, in the form of a template, be created by all lenders to ensure cost-effective and expedient decisions. The components of such a matrix will be similar to the proposals made by the Kamath committee and may include features like disposable income of the borrower, debt serviceability ratios (pre and post restructuring), type of credit facilities (secured/unsecured), etc. Conversely, the regulator, the RBI, may issue such a matrix as a part of a guiding-principle document, while allowing the lender to make suitable customisations on a case-by-case basis. This principle is not only followed by international regulators[13] but has also been echoed by the Indian parliament in the recent amendment to the insolvency and bankruptcy code 2016, where it offered a pre-packaged solution for smaller enterprises[14]. These approaches will also enable the RBI to effectively monitor the activities in the credit market, and at the same time audit entities to measure their adherence to the templates’ letter and spirit.
4. Acting in the customer’s interest: Finally, all lenders must ensure that the decision on whether to offer a customer a remedy aligns with her best interest. In the aftermath of a pandemic, several customers are likely to be in very high distress, and no amount of restructuring or moratorium can provide them relief. Restructuring such cases should be avoided. Conversely, when restructuring is provided, the lenders must account for all the debts of the borrower and her disposable income (not total income)[15] to arrive at a design that is in the best interest of the customer. Further, it is possible that in certain cases, borrowers may need additional credit to resume the full level of economic activity. In such cases, the lenders should be allowed to extend fresh credit as part of the restructuring plan, as is allowed currently in RBI’s Resolution Framework 2.0. However, such approaches used indiscriminately may lead to debt traps for the borrowers. Thus, lenders must act in the best interest of the customer and decide between three competing choices. They may either offer restructuring without additional credit, with additional credit or finally, referring the borrower for debt resolution. Though the lack of a robust personal insolvency regime is a barrier to operationalising the third option of debt resolution, the option must still be acknowledged. Finally, apart from the aforementioned considerations that apply for remedies concerning debt distress, the lenders need to follow uniform, universal and robust conduct guidelines designed to ensure that lenders’ actions remain in the best interest of the customer[16]. Further, the providers should also communicate the borrowers’ responsibilities and initiate the restructuring process in a timely manner[17].
In conclusion, remedies with blanket or ‘one-size-fits all’ design features, prescribed by the regulator, are not the best solution to tackle customer distress arising out of the ongoing pandemic. The efficacy of such ‘top-down’ approaches is likely to be limited, given the lack of proximity between the borrower and the regulator. Further, in a federal jurisdiction like India, local guidelines may greatly differ within the nation, despite a singular shock event. In such cases, the centralised banking regulator is seldom positioned to prescribe customised policies for each region and across different time periods. For example, during the pandemic, apart from national level restrictions on the movement of people and goods, several state or district level lockdowns were observed, suggesting that the economic impact of COVID-19 in India differed both spatially and temporally. Thus, to effectively discharge its dual mandate of systemic stability and customer protection, the banking regulator must design policies that are enabling, and targeted to, the distress and economic realities of the nation, and at the same time allow providers to decide how to offer remedies like debt-restructuring.
[1] And earlier under Resolution Framework 1.0
[2] See “Private Debt Resolution Measures in the Wake of the Pandemic” (IMF, 27th May 2020) ; accessible at: https://www.imf.org/-/media/Files/Publications/covid19-special-notes/en-special-series-on-covid-19-private-debt-resolution-measures-in-the-wake-of-the-pandemic.ashx
[3] See Paragraph 5 of the circular titled, “Resolution Framework for COVID-19-related Stress”; accessible at: https://rbi.org.in/Scripts/NotificationUser.aspx?Id=11941&Mode=0 , Paragraph 1 of the circular titled, “Resolution Framework – 2.0: Resolution of Covid-19 related stress of Individuals and Small Businesses”; accessible at: https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12085&Mode=0 , and the Annex of the circular titled, “XBRL Returns – Harmonization of Banking Statistics”; accessible at: https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11199&Mode=0
[4] See: RBI’s COVID-19 – Regulatory Package dated 27th March 2020 and May 23rd, 2020; accessible at: https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11835 , https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11902&Mode=0
[5] See: “Govt to pay interest on interest for sub- ₹2 cr loans, may hit pandemic services” (The Mint, 3rd October 2020); Accessible at: https://www.livemint.com/news/india/govt-to-pay-interest-on-interest-for-sub-rs2-cr-loans-may-hit-pandemic-services-11601722241003.html
[6] See: Paragraph 16-21 of the circular titled, “Resolution Framework – 2.0: Resolution of Covid-19 related stress of Individuals and Small Businesses”; accessible at: https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12085&Mode=0
[7] See: Banks Consider Extending Moratorium To NBFCs After RBI Provides Clarity (Bloomberg Quint, 5th May 2020); accessible at : https://www.bloombergquint.com/economy-finance/banks-consider-extending-moratorium-to-nbfcs-after-rbi-provides-clarity
[8] See: “A Customer-Protection Perspective on Measuring Over-indebtedness” (Jessica Schicks, 2013); Accessible at: https://www.european-microfinance.org/sites/default/files/document/file/Finalist%20Paper_Schicks_I.pdf and “Detecting Over-Indebtedness while Monitoring Credit Markets in India” (Dvara Research, 2020); accessible at: https://www.dvara.com/research/wp-content/uploads/2021/01/Detecting-Over-Indebtedness-while-Monitoring-Credit-Markets-in-India.pdf
[9] See: Paragraph 6 of the Chapter 2 of the “Report of the Expert Committee on Resolution Framework for Covid-19 related Stress”; accessible at: https://rbidocs.rbi.org.in/rdocs//PublicationReport/Pdfs/EXPERTCOMMITTEED58A96778C5E4799AE0E3FCC13DC67F2.PDF
[10] ibid
[11] ibid
[12] See: Paragraph 2.i of the “Report of the Expert Committee on Resolution Framework for Covid-19 related Stress”; accessible at: https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=1157
[13] See: “COVID-19 support measures: Extending, amending and ending” (Financial Stability Board (FSB), April 2021); accessible at: https://www.fsb.org/wp-content/uploads/P060421-2.pdf
[14] See: Paragraph-2 of the section titled “Statement of Objects and Reasons”, of “The Insolvency and Bankruptcy Code (Amendment) Bill, 2021 (104 of 2021)”; accessible at: https://ibbi.gov.in//uploads/legalframwork/0cb67dc13cd3fdc59eddb4cc67226fc7.pdf
[15] See: The Finalised Guidance on “Consumer credit and Coronavirus: Tailored Support Guidance” (January 2021); accessible at: https://www.fca.org.uk/publication/finalised-guidance/consumer-credit-coronavirus-tailored-support-guidance-jan-2021.pdf and the Finalised Guidance on “Mortgages and Coronavirus: Tailored Support Guidance” (March 2021); accessible at: https://www.fca.org.uk/publication/finalised-guidance/mortgages-and-coronavirus-tailored-support-guidance.pdf
[16] See: “Universal Conduct Obligations for Financial Services Providers Serving Retail Customers” (Deepti George, 2019); accessible at: https://www.dvara.com/research/wp-content/uploads/2019/05/Universal-Conduct-Obligations-for-Financial-Services-Providers-Serving-Retail-Customers.pdf
[17] See: “Guidelines on Loan Restructuring for Individuals” (Bank of Albania, ND); accessible at: https://www.bankofalbania.org/rc/doc/eng_udhezuesi_per_individet_11812.pdf
Cite this item
APA
Bhattacharya, D. (2021). Addressing Borrower Distress- A Principle-based Approach. Retrieved from Dvara Research.
MLA
Bhattacharya, Dwijaraj. “Addressing Borrower Distress- A Principle-based Approach.” 2021. Dvara Research.
Chicago
Bhattacharya, Dwijaraj. 2021. “Addressing Borrower Distress- A Principle-based Approach.” Dvara Research.
