Retail lending is like riding a tiger

The credit industry in India is undergoing a litmus test while trying to balance risk and growth dynamics. The age-old adage “He who rides a tiger is afraid to dismount” holds truer now than ever before for India’s retail credit industry which has grown rapidly in the last decade.

However, the Covid-19 pandemic has posed unprecedented challenges to India’s retail credit expansion. Post Covid-19 and its associated lockdown, quite expectedly, we are witnessing a slowdown in lending volumes. Retail credit growth (YoY increase in balances), which had considerably weakened in 2019, slipped further by 2 per cent in May 2020 owing to limited credit activity in the initial months of lockdown.

This moderation was observed across all major retail credit product categories and lender types. However, in recent months the credit demand has picked up and we have seen a consumer lending bounce back to about 80 per cent of the pre-Covid levels.

This slowdown in growth was driven by two factors:

Dwindling consumer demand based on general conservatism and pessimism; and risk aversion by lenders on the supply side conscious of the lockdown-led spike in delinquencies.

Retail lending, structurally is an inherent and high velocity dance between the balance-sheet and the P&L, perhaps more so than any other business. Capital held as assets, other than those for capital adequacy norms/statutory requirements, is a vain cost that must be converted to loans, which then become income-earning assets.

This is due to the fact that every credit transaction, unlike most other businesses, has a pre-fixed and steady amortisation which depreciates the asset towards zero. As the loans amort, the equated monthly instalment (EMI) breaks up into interest income in the P&L and brings cash back into the balance sheet, ready for redeployment. The amortisation in retail loans works in a way that during the initial part of the tenure, most of the EMI goes into the P&L, as interest income since the interest forms the larger component versus the principal amount.

As the loan grows in vintage, this equation reverses and the principal now becomes the larger component. Therefore, new loans are higher on interest income and older loans are higher on asset book depletion.

Managing maturity profile

This is the reason why we say retail lending is like riding a tiger or running on a treadmill. It is important to manage this all-important maturity profile i.e. the summation of the residual tenors, as an outcome of both the rate of growth of new loans and the “run off” in the old loans.

Write offs/loss ratios also look better in low vintage books, as the book is still fresh.

It is proven over time that the highest delinquency in retail books, is typically seen between 25-60 per cent of the loan tenor. Let us understand this better through the following scenarios:

(a) If we were to take the sum total balance outstanding (live earning assets and net of write offs) as the denominator and the delinquent balance as the numerator,

1. a higher percentage of a new book in the denominator will suppress the delinquency percentage.

2. Similarly, a higher percentage of an older book will inflate the delinquency percentage.

Therefore, the overall health of the loan book depends heavily on the rate of the growth of the denominator, that is, new loan acquisition versus the rate of the growth of the numerator, which is the result of delinquencies from older vintages or loans which are 12-18 months old, where the weighted tenure is typically 36-48 months or between 25-60 per cent of the tenure.

(b) A higher percentage of a new book means more interest income, as mentioned above, due to the process of amortization. On the other hand, older books suffer delinquencies but on a smaller principal outstanding, which means the delinquency percentages will be high and that’s a big negative for the investors and stakeholders, which sends a lender into a vicious cycle where the next round of capital is scarce and gets more expensive. Which then has a spiralling effect, forcing a lender to lend at higher rates, which in turn attracts relatively higher risk portfolios and thereby deteriorating portfolio quality. Since borrowers with good credit scores will have better bargaining power and will therefore go for lenders who provide a lower rate of interest,

(c) Typically, retail loans are classified as non-performing assets (NPA) at 90 days past due and income recognition is stopped. The P&L is prepared for the eventual write-off of the remaining loan amount, by keeping aside a “specific provision”. This provision, is paid for by the interest income.

Risk of imbalance

Now, if we read these three factors together in conjunction to each other, we can see the risk of a systemic imbalance if there is a huge slowdown in disbursements.

When risk averse, lenders tend to tighten their credit policies. Upping norms is not an easy solution, as there is a definite shift in the population distribution of people applying for new loans.

During downturns, it is observed that good borrowers (low risk) also tend to become more conservative. Lenders calibrating their policies to avoid adverse selection (or even type I/type II errors) is a very critical step and needs careful iteration in order to minimise even higher delinquencies in the future.

Lenders therefore need to continue to monitor the credit profile of their borrowers not only within their portfolio, but also across the industry.

Timely identification, interventions and control measures can be undertaken to prevent NPAs and balancing that with a continuous effort to find & fund the good customers is essential for sustained growth, in retail lending.

The writer is Managing Director & CEO, TransUnion CIBIL

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