Unreasonable Banking

A reader has written to me complaining about the penalty banks levy if a borrower repays his loan before maturity; apparently, most of them levy 2 per cent. His argument is that banks should be overjoyed if a borrower returns the money early, because that makes it impossible for him to renege on his debt. The way he thinks of it, every bank is worried every moment about all its borrowers, and about whether any of them will repay their debts. Every time a borrower repays, a bank can stop worrying about him not paying. If he repays early, he saves the bank’s worry for the remaining period of the loan. The bank should reward him for being so nice and reducing the bank’s heap of worries.

I wondered what was the Reserve Bank’s view. This is not a matter on which it has issued an instruction or a notification. But once it was asked what was its policy, and it had to tell because of the Right to Information Act. It has apparently expressed itself only once, on 7 October 2008. Then it said that in 1999, it had given banks operational autonomy; having done that, it had abjured interfering in such matters as penalties for borrowers’ crimes. It advised banks that charges should be reasonable and not much higher than the average cost of providing a service; but obviously, it did not bother to ask what they were charging, let alone tell them they were being greedy or unreasonable.

Since the Reserve Bank, which has issued reams and reams of instructions, has adopted a strictly hands-off policy on this matter, we have absolutely no information on what banks charge, and whether they have any policy at all. Since banks never disclose anything except to the Reserve Bank or on its order, we can despair that there will be any reliable information on this. But assuming my reader is right, his opinion needs to be considered.

First, should there be a prepayment charge at all (the reader called it a foreclosure charge, but this is not foreclosure)? A bank would argue that if a borrower prepays, it loses a good borrower, and that it must find another borrower. That involves work and risk, for which it must be paid. As far as I know, banks charge for this already; there is a charge when a loan is first given, which is supposed to cover things like the cost of documentation, etc. This charge should cover the entire cost of making a loan — of finding a borrower, judging his reliability and assessing the risk of lending to him. If the initial charge covers all the costs relating to a new loan, then early prepayment would involve no cost at all, and should be allowed without any charge.

A bank may, however, decide not to charge the entire initial costs. In that case it would be entitled to take something more from everyone who finishes repaying — including from those who repay early. However, recovering the costs in two instalments, one at the beginning of the loan and the other at the end, would only add complication; it would be much simpler to collect all fixed charges at the beginning. So to me, it makes no economic sense to impose a prepayment charge.

Why then do banks impose one? The only reason I can think of is that bankers incur costs in giving a loan that are not measured in money. In other words, they are lazy, and hate to find borrowers for their money. In their ideal world, the government would borrow everything they can lend, and never repay it. Short of that, they would like to give as big loans for as long as possible. I used to think that the Reserve Bank forced banks to lend to small borrowers and controlled interest on loans to them because the cost of servicing small borrowers was higher. But if a bank is free, as the Reserve Bank says, to recover all the initial costs of giving a loan, all it has to do is to charge a small borrower the incurred costs of assessing him. After that, it should charge him the same as other borrowers. So the reason why the Reserve Bank has to force them to lend to small borrowers is that they are lazy. And the reason why they can get away with being lazy is that there is not enough competition amongst them. Prepayment charge is not particularly unfair; it is just stupid. And the reason banks get away with the stupidity is that the Reserve Bank does not allow more clever bankers to compete the existing banks out of existence.

A lower prepayment charge would be a small benefit of more competition amongst banks. The biggest benefit would be that the fat margins banks make would melt. Banks give depositors 5-6 per cent on their deposits, and lend that money at 15-16 per cent. This is compelling proof that banks are a cartel protected by Reserve Bank’s licensing policy.

The author is Consultant Editor of Businessworld.
ashok.desai@gmail.com