The regulatory minefield on digital lending

It was 1974 and my first formal employment was with Bank of India, Bombay, at the ‘cash’ department. Every employee had a ‘salary’ account, which allowed only cash withdrawals.  On the salary date, we would all take our salary passbook, a withdrawal slip and draw cash as we needed. En route in the passage, stood two gentlemen holding a bunch of salary passbooks.  Some employees would stop, collect the passbook, withdraw salary, come to the person and hand over some cash and the passbook too before leaving.  Of the two, one was an outsider, a Pathan. And the other was a peon from our branch.  I was very curious.

The birth of payday loans

I went across to a senior who was known to me and asked him about why bank employees handed over their salaries and passbooks to these gentlemen. He explained that the two gentlemen were moneylenders. They advanced money to salaried employees and collected it back on the payday. Typical loans were of Rs.500 to Rs. 3000.  Repayments would be in ten monthly installments. If you borrowed Rs.1000, you would get between Rs.800 to Rs.700 in cash upfront.

The difference was interest collected in advance for the ten months. The passbook was important, because the employee could withdraw money without it and stayed with the moneylender. A promissory note plus the passbook and signed withdrawal slips were the collateral for these loans with no guarantor. This was my first introduction to ‘payday’ loans.

From payday to BNPL

From those times, the moneylenders may have changed, but payday and other similar loans remain a fact of life.  This informal system has become big, in rural as well as urban India. Over time personal lending from banks, finance companies and private unregistered lenders has proliferated. At any place you go to buy a vehicle or consumer goods, there is a desk manned by two or three gentlemen who give you a loan or ‘interest free’ EMIs or some such variation, to fund the transaction.

Today, we are dealing with the ‘I-want-it-now’ generation which believes that to buy anything, there’s no need to have money. Lenders bombard you with messages and mails reiterating the same philosophy – Simply BNPL (Buy now pay later). You do not even know who is giving you the money. And the interest rate? Does not matter so long as the EMI is manageable. GDP growth too gets a leg up from such easy lending which brings future consumption to the present with money being produced out of thin air. 

The latest to join this bandwagon is digital loans that originate from mobile ‘apps’ or applications on your phone. There is not even the minor inconvenience or discomfort of having to approach a lender and seeking a loan. There is anonymity in borrowing and lending. However, these modern-day lending weapons are and should be a source of big worry to the regulators. 

As a result, RBI as the regulator for lending and borrowing, now has its hands fuller than ever before. Barely able to regulate lending in banks, NBFCs and other ‘regulated’ entities, it is now faced with an unknown element that has entered the game. And I am not even thinking of crypto funny money, which is giving a big headache to governments worldwide. It is not surprising that RBI, facing fire from all sides, should set up a working group that has put up a white paper on the issues that face ‘digital lending’. I recall reading some months ago that there were 1100+ lending apps and that nearly 600 were illegal.

Mission Impossible

Regulating this is going to be Mission Impossible. For the regulator to monitor these loans, the process now starts from finding the app engaged in lending, to the manner in which the ‘lender’ recovers the last instalment. There’s an added element of data privacy and data protection and misuse of the borrower’s data as well. So, the regulator’s touch-points in supervising digital lending need to cover technology, process, fairness, disclosure, truth in lending, recovery methods, violation of privacy of data, use of that data, source of money, taxation, GST and more. This in my view is simply not going to be possible. 

The working group report goes into the micro-management aspects of the entire sequence and recommends regulatory watch and supervision at multiple stages by multiple agencies. There is even a recommendation for forming a Self-Regulatory Organisation (SRO).  RBI has been under fire for failing to address multiple instances of non-compliance with prudential norms and defaults by mainstream lenders such as banks and NBFCs until the problem became so big that something had to be done.

It is very unlikely that it will be able to contain this monster that is backed by technology that is so dynamic that you cannot even figure out the source of the money. There are lenders, middle-men, vendors and enablers. The faces and the bodies cannot be easily connected. Those who wish to comply may do so, but those who wish to take short cuts, will have a free pass. I wish some taxation expert was also involved in this because there is also a question of source of money, taxation, withholding taxes and more. 

The Report of the Working Committee can be found here.

I would urge the readers to just read the Glossary of Terms at the beginning of the report to understand the complexities involved in regulating such a space. The focus of regulation is to ensure that there is no exploitation of the consumer, while lending or recovering. 

We have extracted the Glossary of terms from the RBI Working Committee report for your ready reference here.

The report also mentions that the RBI would like to see some specifications on technology. This is dangerous territory. Instead of technology, it would have been easier to specify reporting requirements, a ‘do not do’ list and to insist on the government specifying severe punishment (not just financial) for violation of any of the specifications. The problem with financial wrong-doings in India has been the absence of punishment that can act as a deterrent. Financial penalties are meaningless. They are often paid by the company and never by the wrong-doer individuals. A minimum imprisonment term of five to ten years, would be ideal if there is so much concern about the social disturbances that the lending and recoveries can cause.

A better approach to regulation

Let us look at this from the borrower’s point of view. Any eligible and English literate borrower need not use an app to borrow money. He can probably sign on at the POS (Point of Sale) of the vehicle or consumer good, with a readily available finance company or lender. He can borrow from a known name.  Of course, at the POS also, there will be a middle man pushing an app to download, offer the borrower some freebies etc.  

But borrowers who are most vulnerable to unregulated digital lending and doubtful recovery practices would be the non-English speaking and the bottom of the pyramid person, who will be lured by the bombardment of SMS and fall easy prey to the immediate cash credit. The working group report does not talk about a central database, using a unique identity like Aadhaar, which would actually facilitate online monitoring of borrowings through the digital mode.

It should have focused on that. It could have said that if a loan is not populated into the database, it would be an offence and the penalty would be some 20 times of the loan amount and further that any loan not entered in the database cannot be sued for recovery. These kinds of strong deterrents are what are needed. Not standardization of a moving platform like technology or having an SRO or having a separate regulator.

RBI can make sure that the Google or Apple stores only carry apps that have a license from RBI, if they relate to lending. Here, the RBI can be brutal. Ask for capital adequacy that is kept in the form of a deposit with it. There is some mention of a deposit in the report, but by the time this is implemented, you can bet that this will get diluted to a token amount.

In BNPL or product loans, the lender typically receives two income streams. One is from interest and the other is through subvention funded by the manufacturer. For example, a Rs 10,000 refrigerator with a Rs 500 subvention and a 5 monthly interest free repayment, would translate to a near 24 percent return to the lender! The disclosure should cover this also. Mentioning the true annual rate on the loan plus any other return would help the borrower make the right decision. Most of the borrowers on the fringe will not even understand what is being disclosed and simply sign wherever required, so long as they can buy the product.

I would say the report has good intent, but the focus is wrong. Focusing on operations and processes in the case of technology-intensive businesses, is futile. The industry would be miles ahead of the regulator on these aspects. The regulatory focus should have been on disclosure, fairness and deterrent punishments to protect the borrower’s interests and having high entry barriers for approving digital lenders so that so many cannot proliferate. This has already been the RBI’s biggest miss when it comes to NBFCs and it is surprising that it is being repeated with digital lending.