Tuesday, July 26, 2011

The need to regulate consumer finance

One of the most important lessons to be learnt from the sub-prime crisis is the need for better consumer protection in financial markets. In particular, given the shockingly abysmal level of financial literacy among consumers, it was important to provide atleast the most basic level of protection against predatory practices by financial institutions.

In recognition of this imperative, the Dodd-Frank Bill in the US, last year established the Consumer Protection Bureau within the Federal Reserve Board to write and enforce rules protecting consumers of financial products and also increases the authority of state regulators to enforce protections. It would require lenders and sellers of financial products to provide plain-English disclosures, price comparisons with alternative products and clear tripwires before fees are assessed.

This issue assumes much greater relevance in developing countries where financial liberalization of recent years has brought in its wake a proliferation of attractively packaged financial products. The widespread consumer financial illiteracy coupled with skeletal regulation provides fertile ground for predatory lending practices by unscrupulous financiers to unsuspecting borrowers.

A Times article points to the havoc being wreaked by credit card debts, which have also contributed to the extensive economic growth of recent years, in some Latin American countries .

"It has also opened the door to abuses, as credit issuers have used predatory techniques to lure customers, particularly young and less affluent ones, in countries where regulation is scant, annual interest charges can top 220 percent and consumers cannot seek bankruptcy protection, economists and consumer defense groups say... troubling undercurrents in the South American economic boom: indiscriminate lending, lax regulation and ballooning over-indebtedness of large parts of the population, especially those with lower incomes."

And it points to practices that are reminiscent of those of the sterotype of unscrupulous moneylenders, used by certain retailers in Brazil and Chile who peddle consumer durables on credit,

"... among 418,000 clients (of La Polar) in Chile who fell behind on their payments and had their debts repackaged by the retailer La Polar, which raised interest rates and extended loan terms without their knowledge. In early June, it came to light that executives at La Polar had been unilaterally renegotiating clients’ debts for more than six years... The widespread proliferation of credit has been both rapid and relatively recent, developing over the past decade and spurring a consumer revolution across South America. Retail chains like La Polar in Chile and Casas Bahia in Brazil, which sell electronics and housewares, have thrived by offering relatively low-priced goods and extending easy credit terms to entire classes of people who had never had access to it."

While bank-issed credit cards have been regulated, cards issued for in-store use by retailers have enjoyed "light-touch" regulation, thereby setting the stage for a rapidly emerging household indebtedness problem in these countries.

This issue is all the more dangerous for countries like India with a history of extremities of political populism. Credit-driven financial growth has the potential to be the most dangerous form of populism. Unlike conventional electoral populism, involving handing out doles to the electorate which bankrupts the state, credit-driven populism could first bankrupt the households and then the state (in the process of bailing out the banks and the households). This danger is amplified in countries which are in the nascent stages of their financial market growth, where the major share of financial institutions are government owned and financial illiteracy is the norm.

Consider a scenario where the central bank liberalizes (or is forced into) lending regulations on consumer financing (both credit cards and for EMI-based purchases). Predatory lending is never far away and even state-owned banks too enter the fray with several easy-credit schemes. A consumer debt-bubble gets inflated in which a large number of people, especially from the lower middle-class, become exposed. Come elections and the demands start for some form of loan waiver by an electorate socialized into feeling nothing unethical about such demands. It only requires one unscrupulous political party, and there is no dearth of them, to promise write-offs on all consumer debt owed to PSU banks, to force everyone else to follow suit.

That this is not a far-fetched scenario is borne out by the numerous precedents in our history. Loan waivers have been a common feature of our political landscape for decades now. The recent state supported forced write-offs of MFI loans in Andhra Pradesh is a reminder of the vast possibilities of such a trend.

Further, apart from the political populism associated with write-offs, there are factors which strongly encourage such credit growth. For a start, such credit growth drives economic growth. Businesses make profits, consumers are happy borrowing and spending at apparently easy terms and without any hassles, policy makers are satisfied with business investments that create jobs, and bankers are thrilled at the rapid growth of their business (and lending excesses are inevitable). Most importantly, politicians benefit by keeping all these stakeholders satisfied. So where is the incentive to take away the punch-bowl?

It is in this context that more prudent regulation of the sector assumes significance. Such regulation is required to align the incentives of all stakeholders into driving the overall objectives of consumer credit flow. As the experience of Chile and Brazil shows, with increasing financial liberalization, it is only a matter of time before such practices start showing up.

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