In the world of finance, loans can be broadly categorized into two types: secured and unsecured. The fundamental difference lies in the presence or absence of collateral—assets that act as a guarantee for the lender in case the borrower fails to repay the loan. Secured loans are backed by collateral, while unsecured loans lack this security net. In this article, we explore the dynamics of these loan types, focusing on the Indian context, where unsecured loans (ULs) have been gaining attention and possibly warranting tighter regulations.
Understanding Secured and Unsecured Loans
Secured Loans (SLs) are loans that are supported by tangible assets or collateral. The logic is straightforward: if a borrower fails to repay the loan, the lender can seize the collateral and sell it to recover the outstanding amount. This reduces the lender's risk and often results in lower interest rates for borrowers. Common examples of secured loans include home loans (where the house itself serves as collateral) and car loans (where the vehicle is the collateral).
Unsecured Loans (ULs), on the other hand, are not backed by collateral. These loans are issued solely on the basis of a borrower's creditworthiness. Since there is no physical asset to secure the loan, ULs are considered riskier by lenders. Consequently, ULs are typically extended to highly creditworthy borrowers, and the interest rates charged are often higher than those for secured loans. Common examples of ULs include personal loans and credit card debt.
The Rising Popularity of Unsecured Loans in India
In recent times, unsecured loans (ULs) have been making headlines in India due to their increasing prominence in the country's overall loan portfolio. The Reserve Bank of India (RBI) has been monitoring this trend and might consider tightening regulations to control the growth of ULs. However, it's crucial to note that discussions around ULs have primarily revolved around personal loans and credit card debt, but these loans can have diverse applications, including the purchase of low-value consumer goods.
Furthermore, the Indian government supports the idea of collateral-free loans, particularly for economically weaker sections of society. Initiatives like education loans up to ₹4,00,000 (or ₹7,50,000 under the Credit Guarantee Fund Scheme for Education Loans) and loans for Micro, Small & Medium Enterprises (MSMEs) below ₹10,00,000 with guarantees from the Credit Guarantee Fund Trust for Micro and Small Enterprises are examples of such programs. Additionally, retail microfinance is offered without the need for collateral.
It's worth mentioning that not all credit card debt in India is unsecured. Some banks issue "secured" credit cards, which require financial security, preferably in the form of a fixed deposit. These secured credit cards typically have credit limits up to 90% of the deposit's face value.
Analyzing the Growth of Unsecured Loans
To understand the trajectory of unsecured loans in India, we turn to available data. However, it's important to note that the analysis is constrained by the limited data on unsecured loans, primarily sourced from bank balance sheets. The focus here is on the period from 2014 to 2023 (March-end), and the banks are categorized into three groups: public sector banks (PSBs), old private banks (OPvBs), and new private banks (NPvBs).
During this period, all groups of banks witnessed a notable increase in the amount of unsecured loans and the ratio of unsecured loans to total loans. In aggregate, unsecured loans posted a Compound Annual Growth Rate (CAGR) of 16.07%, with NPvBs leading at 24.31%, followed by OPvBs at 20.12%, and PSBs at 12.27%.
The growth of the unsecured loans to total loans (ULs/TLs) ratio accelerated, especially from 2015-16 onwards. Several factors contributed to this trend, including the government's focus on financial inclusion through initiatives like Pradhan Mantri Jan-Dhan Yojana, increased use of digital payment methods (especially credit cards) after the demonetization drive, resurgence of microfinance post the 2010 crisis, the launch of the Credit Guarantee Fund Scheme for Education Loans (CGFSEL), competition from fintech companies, and banks' efforts to protect or improve their net interest margins.
Additionally, the relaxed lending regime following the COVID-19 pandemic, growing consumerism even in rural areas due to income generation and Direct Benefit Transfer, played a role in the surge of unsecured loans.
Changing Market Dynamics
The share of PSBs in the total unsecured loans market experienced a significant decline during the decade, falling from 76% to 56%. This decline was counterbalanced by NPvBs, whose share rapidly increased from 22% to 40%. However, in 2022 and 2023, PSBs made gains, and NPvBs lost some of their market share. OPvBs remained marginal players in this landscape.
Controlling Unsecured Loans: The Need for Caution
The growth of unsecured loans raises valid concerns. Firstly, easy access to such loans can potentially lead to increased societal indebtedness. Secondly, if borrowers have unsecured loans from different lenders, they may prioritize repaying secured loans or loans from private lenders in the event of financial crisis. Defaults on one unsecured loan can have a "contagious" effect on other lenders.
To mitigate the contagion risk, banks should ensure that borrowers have multiple relationships with the bank, both as depositors and borrowers with multiple facilities. Transaction routing through deposit or loan accounts in the bank can enable the invocation of a "set-off" clause in case of default.
In conclusion, unsecured loans have become a significant part of India's lending landscape, driven by various factors. However, prudent measures are essential to ensure the responsible growth of unsecured loans. Tightening regulations, monitoring borrower relationships, and promoting financial literacy can help strike a balance between expanding access to credit and managing associated risks. Unsecured loans can be a valuable financial tool when used judiciously, but their unchecked proliferation can pose challenges for both borrowers and lenders.