CONSUMER FINANCE: WHAT ARE ITS CHANCES OF SUCCESS?

For the past fifty-four years, commercial banks in Pakistan had completely ignored consumer financing as an activity

By A.B. SHAHID
Mar 10 - 16, 2003 

In a generic sense, institutional arrangements that provide consumers with financing support to enhance their consumption and, as a result thereof, improve their standards of living, should fall within the broad definition of Consumer Finance. These could range from Credit Cards, to finance and operating leases, to housing finance. But the semantics of financial markets generally tend to exclude housing finance from this range treating it as a distinct financing product essentially because of its long-term nature.

For the past fifty-four years, commercial banks in Pakistan had completely ignored consumer financing as an activity. There was scant realization of the fact that the hallmark of healthy economies is not unrealistically high dependence on exports but on domestic demand, and development of indigenous resource and industrial bases that support domestic consumption. Until the early l990s, even Credit Cards were offered to a select band of customers who needed them not by way of financial support but as a convenience for paying their bills while travelling abroad, realizing little that in developed economies this mode of financing supported consumption to sustain steady growth in domestic demand which, in turn, prompted investment and industrialization. Even now, the sudden urge for promoting consumer finance has less to do with accepting this reality; it was spurred largely by a depressed investment climate in which reduced borrowing by industrial and commercial sectors coincided with excess liquidity in banks, thanks to 9/11. Lumbered with liquidity that is nearing unmanageable proportions, banks are now aggressively promoting consumer financing.

The big attraction in extending financing facilities to the passive consumer segment is the prospect of earning high interest rate spreads because consumers are soft targets as far as haggling over interest rates chargeable to them are concerned. They are much more likely to borrow at unrealistically high rates a convenience that is no longer available on lending to industrial and commercial borrowers who now insist on the finest possible loan rates. But in pricing consumer loans unrealistically high, banks would be making a serious mistake because "they cannot charge a high enough loan rate that could compensate for the loss arising out of an irrecoverable loan." More importantly, if consumer finance has to pick-up as a truly helpful mechanism for spurring domestic demand, it must be ensured that it remains within the consumers' capacity to repay their loans on time, and they feel confident about borrowing again and again.

As its is, ordinary consumers' capacity to borrow and repay loans out of their savings has been rendered precarious by decades long cycle of inept economic policies that have made the poor even poorer. Low rise in per capita incomes (whose impact was compounded by falling purchasing power due to rapid depreciation of the Rupee) caused savings to fall and poverty to rise. This combination steadily depressed consumer demand even for the less expensive consumer durables. The sustained trend of depressed demand prevented the development of a sizeable industrial base and contraction in opportunities for investment and employment. In the last two years, steady reductions in returns on savings have further diminished consumers' capacity to repay bank loans.

Banks are belatedly trying to redress this enormous macroeconomic structural imbalance but given the historic pattem of economic developments, they will be handicapped in their efforts to promote consumer finance. Signs are that while lower interest rates have certainly enhanced borrowers' capacity to borrow and service consumer loans, the newly created demand is pushing prices of consumer durables to unrealistic levels. Take, for example, automobiles. Strengthening of the Rupee and substantially lower interest rates should have brought their prices down or at least served to stabilize them. Neither of these expectations were met because the sudden rise in demand created a distortion that allowed assemblers not only to push up prices but also created a roaring black market in this sector. With banks now offering liberal consumer finance facilities for acquiring home appliances, their prices too are on the rise although there is substantial over-capacity in this sector.

Many observers argue that this distortion is a temporary phase, which will soon become history as production capacities increase to fill the large supply gap. May be so, but going by the example set by the automobile industry (in which, so far, only one assembler has announced a "plan" to double its output) this lag may not be as temporary as some observers make it out to be. Banks providing cheap credit to business and industry at the expense of the savers can exercise a powerful influence on the manufacturing sector to push the case for compensating the savers through lower prices. Unfortunately, however, lack of social responsibility in the corporate sector is too pervasive to bring home this realization to the market players.

Aside from the macroeconomic distortions that suppress consumer demand, there are other delicate issues that require focused attention of commercial banks intending to launch a major thrust in consumer finance. The first is the lack of institutional arrangements and practices that hamper the assessment of consumers' re-payment risk. Ideally, risk assessment of employed individuals should not pose as much of a problem as the self-employed individuals because employers could help in providing a basis for establishing the employees' re-payment capacity. That, unfortunately, is not yet the case. Employers appear averse to taking even the feeblest responsibility on account of their employees.

Many employers either don't certify, or certify very inadequately, the financial status of their employees intending to avail a consumer finance facility from a bank. Unless provisions are made in relevant labour laws, employers will not provide even this information about their employees, which they should morally feel bound to provide. Fewer among them are prepared to confirm to the financing institution that they have placed on their records the fact that their employee has availed a financing facility. Fewer still are prepared to accept the responsibility of informing the financing institution in the event the finance-availing employee leaves the employer, or is asked by the employer to leave.

In the case of the self-employed, the problems are complicated further because many potential consumers do not keep credible records of the streams of earnings from their vocations or businesses to permit financing banks a reliable assessment of their future re-payment capacity. Many consumers don't have utility service connections in their names. Given these handicaps, credibly verifying consumers' repayment sources will remain a stumbling block. Unless insurance companies lend a helping hand in this effort by providing loan re-payment guarantees to the lending banks, the prospects of expanding the consumer finance market remain dim. Bankers will have to rely largely on their own credit judgment, which may not always be correct. Given Pakistani bankers' track record in lending, such a possibility will always be there.

A factor that will further complicate extending consumer finance facilities along sound lines are the continuing inadequacies of our legal system that make it cumbersome for borrowers to collateralise their existing unencumbered assets for the satisfaction of the lending bankers. Another thorny issue is the re-possession of financed assets. While re-possessing vehicles doesn't pose too serious problem, re-possessing assets such as air-conditioners, refrigerators, televisions sets, and similar other appliances from households will not be easy. It could be both painful and embarrassing for the lending institutions. Even if these items could be re-possessed, re-selling them to recover book values of outstanding consumer liabilities holds out a challenging prospect. Resorting to shortcuts in risk assessment may therefore lumber banks with thousands of small delinquent loans. In most cases, it may eventually be cheaper to write them off rather than go for re-possession and sale of used assets, or initiate court action to recover loans from defaulting consumers.

Consumer finance is a risky ball game. The infamous yellow cabs scheme was the only big experiment in consumer finance, which was undoubtedly a bad experience for most banks that took part in it. Admittedly, political twists played a big role in the failure of the scheme but operational inadequacies of banks played a bigger role in this monumental failure. A major factor in that failure was the operational deficiencies in banks, particularly in assessing an individual's future repayment capacity keeping in view his or her changing circumstances. Foreseeing impending changes in the circumstances of individuals is not the same as sensing the impact of changing business cycles on major borrowers placed in various economic sectors. Little is available in terms of authentic statistics on this huge customer category. Pakistan Integrated Household Survey (PIHS) is a new report, and its timely release cannot be assured because it may report changes in politically sensitive indicators.

Given the absence of credible sources and bases for assessing risk, dealing with thousands of small borrowers makes consumer finance is a manpower intensive business. Retail banks with large branch networks have the potential for succeeding in this business but it will require making alterations in banks' infrastructure, and a change in the focus on investigative effort for risk assessment. The organization must be pro-active and sufficient in terms of manpower and Management Information Systems to ensure a reaction speed that is commensurate with size of the customer base. In this regard it will be crucially important to ensure that administrative resources are matched with the size of customer base on a continuing basis. Until recently, oblivious to the emerging possibility of creating a large consumer finance market, banks were closing down branches and laying-off employees. Admittedly, there was a need for pruning the banks of deadwood but voluntary retirement schemes led to separation of many experienced hands who could have been re-deployed in consumer finance units because they knew the essentials of risk assessment. Banks will now have to inject fresh (and inexperienced) blood in their organizations to support their consumer finance operations.

Admittedly, consumer finance spurs consumption and demand that is necessary for the industry to expand its productive capacity or make fuller use of its existing excess capacity, and succeed in cuffing prices at the retail level. It also offers the prospects of increasing employment and, possibly, fresh investment in industrial sectors, especially those producing consumer durables. However, the key to sustaining the consumption-demand equation without pushing inflation to unsustainable levels is the maintenance of the critical balance between savings, investment and borrowers' debt-servicing ability.

There is considerable truth in the observation that lowering of interest rates by Central Banks in the mid-1990s, ostensibly to spur demand and economic activity, resulted in acquisition of excessive amounts of "easy" bank credit by businesses and creation of over-capacity there from. Similarly, households too acquired credit (far in excess of their capacity to save and repay) for investing houses, consumer durables and company shares on visibly inflated prices. The credit boom, and the demand created there from, led to meteoric rises in prices and deluded industry into over-investing in capacity building. Eventually, unsustainable burden of debt-servicing forced businesses to crash, and households ended up with negative equities.

Maintaining the critical balance between savings, investment and borrowers' debt-servicing ability is possible if input prices remain stable affording businesses to sustain their profitability, and interest rates too remain stable to ensure that, in the medium term, debt-servicing burden remains affordable for both consumers and manufacturers. Unless the system can ensure the maintenance of this delicate balance, economic instability will remain a strong possibility. Countries that tried to achieve an over-kill in spurring domestic demand sometimes overlooked the importance of maintaining this critical balance. We too are trying to achieve the same objective but regulators must ensure that we don't fall in that dangerous trap. Pakistan's economy, already rendered fragile by industrial sector loan losses, simply cannot live through another major upheaval caused by pervasive delinquency of consumer loans.