Introduction
Credit is provision of availing the benefit of a tangible or intangible resource without paying immediately and an agreement to pay the same at a future point in time. The payment terms can vary with type and amount of credit. Credit is usually given after ascertaining the creditability and capability of the borrowing party. Credibility is accessed by analysing the behavioural patterns of the borrower and his willingness to pay. Capability, on the other hand, is the capacity or potential of the borrower to be able to pay back the credit
Consumer credit is a popular form of credit and can be defined as extending a loan or credit to individuals for consumption and investment purposes, with an expectation of repayment in future. The repayment typically constituents of small instalments scheduled over a period of time, rather than a one-time bulk repayment. This gives flexibility and ease to a consumer. Consumer credits are an important tool to provide immediate liquidity to individuals and assist them to fight back their poverty and low income. However, if the loan is not structured as per the need of the consumer, it can become an individual’s biggest curse. Responsible lending, thus, becomes important for the financial institutions extending credit to the consumers.
This objective of this paper is to discuss the aspects of responsible lending and the need to protect individuals through governmental provisions. The paper is divided into four sections. The first section discusses the key aspects of responsible lending. The section highlights the role played by government in protecting individuals who avail the consumer credit facility. The third section illustrated an application of consumer credit in a real life situation. The fourth section concludes the paper.
Responsible Banking in Lending Consumer Credit
Consumer credit improves the quality of life by enabling purchase of items that provide comfort and contributing to wealth accumulation. The liquidity provided through consumer credit empowers people financially. Some examples of consumer credit are mortgage credit, personal loan and auto loans. Mortgage credit enables individuals to own the house they live in, which increases comfort and acts as a good investment. Personal loans can be availed for personal exigencies, education and for celebrating lifetime events like marriage. However, the biggest threat with consumer credit is irresponsible lending.
According to Tuffin (2009), the credit markets in the United States, Australia, and United Kingdom have all experienced the negative consequences of irresponsible consumer lending. Irresponsible lending comprises of incomplete documentation, inadequate assessment of the borrower’s credit capacity, excess lending, creating information asymmetry, inappropriate loan structuring and heavy reliance on the underlying assets.
Inadequate Assessment of Borrowing Capacity
With increasing competition in the field of credit lending, especially in the mortgage loan segment, the range of product offering has increased. The lenders have developed innovative, yet risky products to cater to those who do not qualify in the traditional lending models. There is a shift is the lending pattern and the poor are increasingly becoming a part of the consumer credit industry. However, in doing so, the lenders have failed to ensure proper due diligence for the loans disbursed.
The increasing competitiveness has forced the lenders to design products and processes that are more and more consumer friendly. In many cases, lenders do away with the basic minimum documents required to assess creditworthiness of borrowers, in a competition to make their offerings hassle free. The adverse impact of this is incomplete documentation to assess the individual’s creditworthiness. Chances of over lending are very high due to inadequate assessment of borrower’s credit limit. Excess lending can increase the vulnerability of low income group people as they do not have a back up to pay off the loan.
Excess Lending
Excess lending is the consequence of a variety of factors that include predatory practices to attract customers, apart from the one discussed above. Customers are influenced through extensive marketing, aggressive sales, and cross selling. Marketing and advertisement influence customers using emotions and need creation for the product offering that leads to purchase behaviour. By setting unrealistic targets for its sales team, lenders push sales. The sales team may also make false commitments to ensure sales. The sales team may also resort to lax in bank norms to ensure sales. Such consequence of these actions is primarily borne by the borrowers.
According to Hewitt (2003), 20% of households in the United Kingdom who have credit face financial crisis and 7% have been associated with over indebtedness.
Informational Asymmetry
The process of loan sanctioning is a very complex one. It entails detailed legal documentation and requires understanding of technicalities. It becomes difficult for an average customer to comprehend it thoroughly. The borrower has to rely on the sales team of lenders to understand the fine prints of the loan. It builds in a lack of transparency in the system and leaves a scope of manipulation.
According to Hewitt (2003), 56% of the borrowers in the United Kingdom do not understand the meaning and implications of the terms and conditions.
Inappropriate Loan Structuring
The determination of the loan amount, interest rates and tenure of the loan, and scheduling repayments all constitute a part of the loan structuring process. It is essential to structure loan in a way that provides ease and flexibility of repayments to the borrower. However, with increasing number of customers, lenders fail to provide a tailor made product to its customer. The institution of additional charges like loan processing charges and pre-payment penalties also hurt genuine customers.
Inferior quality loans (subprime loans) are charged with higher rate of interests, thereby increasing financial burden for those who are already cash entrapped. According to the Carsey Institute (2006), the subprime mortgage loan market in America increased about 3.5 times between 1996 and 2004.
Increasing Reliance on Underlying Asset
Another example of irresponsible banking is the increasing reliance on underlying assets that has been bought on credit. Rather than, assessing the borrower’s ability and willingness to pay, the lenders are keener to extend credit on the value of the underlying asset. This scenario is prevalent in the home loan and auto loan business. When the price of these assets depreciates considerably, the borrower may not have the incentive and ability to pay back the loan. Hence, the chances of such loans going bad are high. The impact of the same will be seen on other genuine customers who wish to avail loan, but the lenders have become too cautious.
Responsible Lending Laws
Responsible Lending Laws are important to ensure transparency and minimise excess lending. However, role played by the regulatory authorities seems inadequate in the given context of lenders suffering from high levels of bad loans and borrowers suffering from financial crisis. The lenders are better aware of the prevailing laws and influence customers to sign documents that safeguard lenders from the legal purview.
Some proposals for instituting responsible lending laws are mentioned here. First, the distortion of information by the lenders can be taken care by mandating the loan documents to be in local language and easy to understand, and by establishing customer grievance resolution cells. Second, regulators should provide a set of indicators to the lenders on the ratio of the loan to the value of the underlying asset and net disposable income of the borrower. Third, categorisation of lenders by providing additional accreditation or certification for good lenders, based on their lending track record. Fourth, the advertising and marketing activities of the lenders need to be regulated to avoid instances of over commitments. Last but not the least, heavy penalty and sanction needs to be imposed for cases of irresponsible lending that comes to the notice of the regulators.
Application of Consumer Credit in Real Life Situation
Importance of consumer credit in the real life cannot be undermined. Mortgage loan has become an essential part of a person. However, having done this course, I will take a set of precautionary measures to ensure I do not get into any financial difficulties. First, I will check for the track record of lenders and identify a set of good lenders. Second, I extract detailed information about the product proposition of the identified lenders and select the best. Third, I will ensure that all the commitments of the lender are provided in writing. Fourth, I will read through the entire set of documentation before signing. Fifth, I will perform as self-assessment of my credit limit with the help of indicators provided by the regulators. Sixth, if the promises are not fulfilled I will approach a grievance resolution centre.
Conclusion
Consumer credit is a revolution in providing economic empowerment to the poor and low income class of people. But, if availed in excess, it can become disastrous and lead to financial difficulties. They key practices of irresponsible lending adopted by lenders are excess lending, inadequate assessment of borrower’s creditworthiness, heavy reliance on underlying assets and problems with loan structuring. The government has a key role to play in protecting individuals from irresponsible lending practices. It can do so by empowering the individuals, enabling access to more information and effective channelization of consumer complaints. The paper equips me to better handle processing of mortgage loan in future when I plan to purchase a home.
References
Tuffin, Jessica (2009). Responsible Lending Laws: Essential Development or Overreaction? Queensland University of Technology Law and Justice Journal, 9 (2), 280-310
Hewitt, Patricia (2003). Fair Clear and Competitive: The Consumer Credit Market in the 21st Century. Retrieved from http://www.berr.gov.uk/files/file23663.pdf
Carsey Institute (2006). Subprime and Predatory Lending in Rural America: Mortgage Lending Practices that can Trap Low-income People. Retrieved from http://www.carseyinstitute.unh.edu/publications/PB_predatorylending.pdf
