Ban on flexi-loans: Should RBI be flexible?

The defining feature of a flexi-loan is amortisation. Instead of a blanket ban, the regulator may consider certain structural safeguards against evergreening

The Reserve Bank of India (RBI) issued draft directions proposing restrictions on 'revolving credit' facilities offered by non-banking financial companies (NBFCs) on August 6. The restrictions are not applicable to credit cards issued by NBFCs.

 

The deadline for offering feedback on the draft amendment was August 28. In an interview with CNBC TV18 last week, RBI Governor Sanjay Malhotra said, “It was never the regulatory intent to allow NBFCs to give revolving line credit… We will look into the various comments (on the draft), weigh the pros and cons … and take an appropriate view.” This has encouraged me to put up my perspective on the matter.

 

It is a welcome move, as the regulator wants to prevent evergreening, ensure timely recognition of borrower stress, and contain excessive leverage. (Evergreening is a practice where a lender issues a new loan to a struggling borrower to enable them to use the fresh funds for servicing an old loan that has turned bad). But the key question is: Do all revolving credit facilities carry the same risk?

 

NBFCs offer a diverse range of credit products. While several of these products may not fall squarely within the definition of a 'term loan' under the draft directions, they are also distinct in their structure and purpose from conventional revolving credit facilities such as credit cards and overdrafts offered by banks.

 

The credit products that offer customers flexibility to draw and redraw loan amounts are called 'flexi-loans'.  While they may incorporate features associated with revolving credit, they are structured to meet specific financing requirements of micro, small and medium enterprises (MSMEs) and individuals, and should be viewed in the context of their underlying use and product design.

 

Such products are used across supply chain finance, including factoring, working capital demand loans, secured and unsecured MSME loans, vehicle dealer financing offered by captive and other auto-finance NBFCs, personal loans, and loans against securities, besides products offered by fintech-based NBFCs.

 

A flexi-loan is structurally different from an open-ended revolving credit facility.

 

In revolving credit, a lender gives you a maximum credit limit. You can borrow money, pay it back, and borrow it again. Your available balance resets as you pay the balance down. 

 

A flexi-loan is a pre-approved credit line or overdraft facility where you can withdraw money as needed and only pay interest on the exact amount you use – and not the full sanctioned limit.

 

In other words, it is an amortising term loan with a limited ‘redraw’ feature. (Amortisation refers to the gradual payoff of a loan through regular, scheduled payments over time.) The maximum permissible outstanding declines according to a predetermined amortisation schedule.

 

Contractual instalments are mandatory in such loans; missed instalments render a loan non-performing. The sanctioned exposure cannot increase through repayment; the facility terminates on a fixed maturity date.

 

Where is the flexibility, then? Well, such loans allow borrowers to make voluntary excess prepayments within the original amortisation schedule.

 

A blanket ban may have unintended consequences – particularly for MSMEs, self-employed borrowers, and households with uneven cash flows. Potentially, a ban can increase dependence on informal lenders and even credit cards. Besides, in the absence of such loans, borrowers may need multiple standalone loans, fresh underwriting, and repeated documentation. This will raise the cost for a borrower through processing fees, stamp duty, and prepayment charges (where applicable).

 

Consider this: A borrower wants to make a voluntary prepayment of Rs 2 lakh. Under a flexi-structure permitting free voluntary prepayment and redrawal, the borrower may reduce the outstanding balance without a prepayment charge and retain access to that amount within the declining redrawal limit.

 

Under a conventional term loan carrying a 4 per cent prepayment charge, the same transaction could cost Rs 8,000, plus applicable GST.

 

If the borrower requires the Rs 2 lakh again, a fresh loan could entail an additional processing fee – say approximately 2 per cent or Rs 4,000 – along with applicable stamp duty and documentation costs.

 

The cumulative transaction cost could rise to around Rs 13,000, compared with little or no cost under the flexi structure, depending on the contractual terms. For a small business operating with volatile cash flows, this is a significant amount.

 

The absence of a flexi-loan facility may fragment a borrower's indebtedness across multiple loan accounts and repayment schedules. Multiple loans may lead to a deterioration in credit scores. Also, since there is no incentive to prepay, borrowers may lose the ability to temporarily deploy surplus cash against debt even when they have money in hand.

 

No one can question the underlying supervisory concerns. In a genuinely open-ended revolving facility where repayment continually restores the sanctioned limit, there is no mandatory amortisation, and the exposure can continue indefinitely, potentially covering up a borrower's stress and facilitating evergreening. The concern assumes greater relevance where an NBFC does not know how much money is in a borrower's operating bank account.

 

However, thanks to the account aggregator network, many NBFCs these days have visibility of the borrower's bank account. (An account aggregator is a regulated financial intermediary that aggregates a borrower's financial exposure across different institutions using digital consent.)

 

The proposed restriction needs to distinguish between products that can perpetually refinance exposure and those that contractually amortise to zero. This distinction is crucial, particularly for MSMEs and underserved borrowers, for whom flexible formal credit can bridge seasonal, irregular, or volatile cash flows.

 

A flexi-loan follows a predetermined repayment schedule, mandatory contractual instalments, and a fixed maturity. Its principal distinguishing feature is that borrowers may voluntarily prepay amounts over and above contractual dues and subsequently redraw those excess amounts, without exceeding the outstanding amount permitted under the original arrangement.

 

The structure typically incorporates the following safeguards:

 

# Redrawals cannot exceed cumulative voluntary excess prepayments available to the borrower;

 

# Principal outstanding cannot exceed the balance permissible under the original amortisation schedule;

 

# Contractual instalments must be paid when due and cannot be funded, adjusted, or deemed paid from the available redrawable amount;

 

# EMIs or monthly instalments continue to be billed irrespective of the applicable redrawal limit;

 

# The original maturity date cannot be extended through redrawals;

 

# Additional borrowing requires fresh underwriting; and

 

# Stricter delinquency rules need to be followed compared with other revolving facilities offered by banks.

 

Top-up loans are dealt with separately, as are conventional term loans.

 

At no point during its tenure can a flexi-loan's outstanding balance exceed what would have been permissible under the corresponding conventional term loan amortisation schedule.

 

Also, the borrower must pay each contractual instalment on its due date from independent funds. An available redrawal limit cannot be used to offset or regularise an unpaid EMI. Failure to pay makes a loan bad; depending on the duration of missed instalments, its status is determined in accordance with prudential norms. Simply put, the existence of an unused redrawal limit neither prevents nor defers the recognition of a borrower's stress.

 

This is the basic difference between a conventional revolving facility and a flexi-loan, where both the permissible outstanding balance and the redrawal entitlement progressively decline and ultimately reach zero.

 

Instead of a blanket ban, the RBI may consider certain structural safeguards against evergreening. For instance, redrawal rights can be blocked temporarily or even permanently, based on a borrower's repayment behaviour, including EMI delays.

 

Most importantly, an undrawn limit cannot be used to service an unpaid contractual instalment, restore the original sanctioned exposure, extend contractual maturity, or prevent the recognition of delinquency.

 

At an industry level, flexi-loans are estimated to be around Rs 2.5 trillion. Borrowers' access to funds and the continued formalisation of credit are more important issues than the impact of the ban on NBFC asset growth. The need of the hour is to define what creates evergreening risks and restrict those mechanisms, rather than a ban on all products that feature a redrawal facility. Transparent, self-liquidating, and fully amortising facilities with fixed maturities and mandatory repayment obligations should be treated differently.

 

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The writer is an author and senior advisor to Jana Small Finance Bank Ltd. His latest book: Roller Coaster: An Affair with Banking. To read his previous columns, log on to www.bankerstrust.in. X: @TamalBandyo