General Awareness Updates – October 2009

Miscellaneous-2

Retail Finance: I need a loan!

Retail Finance can broadly be classified into Retail Assets and Retail Liabilities. These assets and liabilities are defined from the perspective of the Lender – a bank or a financial institution. When a bank lends money to a person, the money thus lent is called a Retail Asset. When a bank collects money from a depositor it becomes a Retail Liability. In this article, we will discuss the dynamics of the Retail Finance sector.

Hypothecation. When a person takes a loan from a bank to purchase a car, the underlying asset is the car. There will be an entry in the Registration Certificate of the car stating that the car has been purchased under a loan agreement with the bank. This is called hypothecation.

Let’s say, a car has an on-road price of Rs.6 lakh, i.e. this price includes the showroom price of the car, local taxes, registration amount, and insurance premium for the first year. The buyer of the car will be required to pay a small percentage of this amount upfront. This is known as the Margin Money. Let’s assume that this is 20 per cent of the total cost. The bank finances the remaining 80 per cent of the cost and this becomes the loan amount. The rationale for the Margin Money is to create a sense of ownership for the underlying asset in the mind of the borrower also. In a highly competitive market, some banks finance 100 per cent of the vehicle’s on-road price.

EMIs. The buyer and the financing institution get into a contractual agreement that the loan amount will be repaid in a particular number of EMIs or Equated Monthly Installments. Usually, EMIs are spread over a period of 12 to 72 months. Let us reiterate that the contract is between the vehicle buyer and the bank – the automobile manufacturing / dealer company is not a party to the contract. The bank then pays this loaned amount to the dealer company from whom the car is bought. Once the car is delivered to the buyer, the collection of the loan amount is the bank’s responsibility. To this end, banks usually collect post-dated cheques for each EMI.

Risk. After the borrower has paid all the EMIs, the bank issues a certificate to the effect that the hypothecation on the Registration Certificate can be cancelled. Only then the borrower-owner who has been using the car all these years, becomes the true owner of the car.

From the perspective of the bank, there is a risk involved in financing the asset. The risk pertains to non-payment of the EMIs. Also banks need to make money on this transaction. Where does the bank get the Rs.4.8 lakh to lend? This money comes in through the Retail Liabilities route i.e. this is the money that another person has deposited with the bank. And the bank has to pay interest to the depositor. Thus the car loan transaction has to take care of the interest component, the risk the bank is assuming in financing the asset, and the administrative and marketing costs.

Rate of interest. The difference between the interest at which a bank accepts and lends money is known as the ‘Spread’. In highly competitive markets, the spread is usually very thin and so the bank cannot afford a disruption in the cash flow. Things go wrong when the person who has taken the loan defaults on payment. When that happens the underlying asset is classified as a ‘Non-Performing Asset’ (NPA). So, the quality of disbursements (to potential borrowers) is of critical importance. Banks employ a “Field Investigation Agency” to assess the potential borrower’s “capability and intention to repay” (also called creditworthiness).

Rate of return. The interest rate charged by the bank is usually publicised as the ‘flat rate’ of interest. This communicates the apparent rate of interest. If the flat rate of interest is 8 per cent for three years (36 months), the total repayment amount for a loan of Rs.1 lakh would be Rs.1,24,000, with an EMI of Rs.3445. But we need to understand that the real rate of interest is not 8 per cent as communicated.

Banks are interested in the ‘Internal Rate of Return or IRR’. This is the real rate of interest. In the example quoted above, the IRR would be 14.56 per cent. In case the bank’s conditions stipulate one advance EMI, then actual loan amount gets reduced by the amount of one EMI, the repayment period becomes 35 months and the IRR would be 15.47 per cent. We need to understand that this is the only rate that really matters for the bank.

The IRR depends on the timing of the cash flow and not just on the quantum of money coming in. This is why some banks might even consider giving a ‘prompt payment rebate’ in the final EMI if the full payment has been made on time. What we are discussing here is the most central concept in finance – “the time value of money”. The time-value of money simply can be understood through an age-old adage: ‘A bird in hand is worth more than two in the bush’.

Money receivable always has a risk element attached to it. Many times, we come across the statement – Zero Per Cent Finance. Now, let us clearly understand that a concept called 0 per cent finance does not exist. It cannot exist because it contradicts the fundamental driver of business and trade – ‘the time-value of money’.