he recent Reserve Bank of India notification on vendor subvention loans, >zero-cost credit card EMI (equated monthly instalment) loans, and so on will go a long way to create an environment for truth-in-lending regulations. Truth-in-lending laws, found in many countries ensure that lenders make a truthful disclosure of their rates of interest, and do not try to attract borrowers with misleading rates of interest. Truthful disclosure of rates of interest is as important as fair disclosures made by a vendor selling goods.
There was a time when there was no truth in lending in India at all. A lender could get away with disclosure of what was called ‘flat rate of interest’, which was almost like half of the actual interest rates. Leading housing finance lenders would show what was called ‘annually declining rate of interest’, which was also deceptively lower than the actual interest rates. It was in 2009 that the RBI required disclosure of the actual rates of interest in case of loan transactions.
Supplier subventions
Most comments from the financial press on the recent RBI notification focused on the credit card EMIs. Credit card issuing banks quite often promise an interest-free EMI loan if a particular card is used for a particular purpose, say, travel booking. There are no free lunches in life; neither is there any interest-free credit in the world of banking. It is just that the bankers are getting merchant commissions from the respective merchants offering the services — in this, the airline or the travel company from which the interest is being made up.
However, the financial world has not been able to see or stress on another part of the RBI notification, which pertains to supplier subventions in asset-backed financings. This pertains to financing of assets such as cars, commercial vehicles, construction equipment, infrastructure assets, and so on. Typically, subventions come in two ways: a supplier interest-free credit, for a certain period, say, 6 months and a supplier commission — these are typically based on volumes achieved, and may go up several percentage points.
The arrangement is, when a bank or a non-banking financial company (NBFC) gives asset-based financing to a client, the supplier may provide a credit, or commission or both. Thus, the lender charges a lower interest rate from the borrower, and makes up for the same by way of credit, or commission or both.
The accompanying Table gives a view of the impact of the commission and credit.
As may be seen from the Table, an actual implicit interest cost of 13 per cent may be dressed up as only 8.54 per cent if the lender is a getting a supplier’s credit of six months. And this may sound tempting enough. Not that the borrowers are not aware that banks will not be willing to lend at 8.54 per cent, and there is something which is not meeting the eye — however, the opacity is all that clouds decision-making, and breeds unfair practices in the market.
Supplier subventions are common place all over the world of asset-backed financing — manufacturers of automobiles, commercial vehicles as well as construction equipment, and even IT sector (all actively try to promote the sales of their products through subventions). And interestingly, this practice is not limited to India — it spreads all over the world.
The RBI dictat
The notification puts a curb on subvention-based financing. In strong words, the RBI says: “If there is a discount offered in the price of a product, the loan amount sanctioned for the purchase should be after taking into account the discount, rather than giving effect to the benefit by reducing the rate of interest (RoI). Similarly, if there is a moratorium period for payment available, the benefit should be passed on to the customer by ensuring that repayment schedule, including the interest servicing, commence after the moratorium period only rather than adjusting it in the RoI. Thus, in principle, banks should not resort to any practice that would distort the interest rate structure of a product as this vitiates the transparency in pricing mechanism which is very important for the customer to take informed decision.”
Advantage captives
The notification is addressed to banks, but hopefully, this may soon be extended to NBFCs as well. In fact, if it remains limited to banks, there will be a huge arbitrage between banks and NBFCs, since NBFCs can still do what banks are now prohibited from doing.
However, one of the issues which may perhaps not have attracted the attention of the RBI is that prohibitions now cast against banks, and prospectively against captives, will put captives to a huge competitive advantage. Captives are finance entities which finance products of their parents.
Most manufacturers of capital assets today have their own captive finance companies as well — in which case, it may not even be necessary for them to pass on the benefit directly in the form of credit or commissions, since, after all, the captives are financed by the parent by way of equity or debt funding. In other words, a parent may finance a captive in different ways — equity, cheaper debt, or otherwise, or may simply participate in the losses of the captive, without having to pass on a specific credit or commission at all. This was to create a non-level-playing field between captive finance companies and others.
Impact of notification
The intent of the RBI — in ensuring that truth prevails in business of lending — is surely laudable. However, it could not have come at a worse time. Asset-based financing is languishing. Defaults and delays are mounting. NBFCs are facing the toughest time over last decade or so. At this stage, anything which affects business will soon worsen into an existential question.
The author is a financial consultant and visiting faculty at IIM Calcutta and National University of Juridical
Sciences (NUJS), Kolkata
