Prepayment penalties: A boon for small firms or a barrier to credit?

A recent draft circular released by the Reserve Bank of India (RBI) proposes banning foreclosure or prepayment charges on loans to small firms and increasing transparency in disclosures. In this article, I argue that while enhancing transparency is welcome, banning prepayment penalties, though well-intentioned, may ultimately be counterproductive in improving access to credit.

  Let us first understand the proposed provisions and the RBI’s likely intentions. The draft circular states that “divergent practices” of lenders concerning foreclosure charges/ prepayment penalties lead to “customer grievances and disputes.” The RBI also appears concerned that lenders include clauses that prevent borrowers from switching to other lenders “either for availing lower rates of interest or better terms of service.” Thus, the RBI seems to believe that imposing prepayment charges allows banks to exercise power to the detriment of borrowers. Therefore, restricting such charges will likely benefit borrowers by increasing their choices. 

  Given its views, it is not surprising that the RBI has proposed eliminating prepayment charges on all floating-rate loans to individuals, except for business loans. For business loans, the RBI has suggested banning prepayment charges on loans up to Rs 7.5 crore extended to small firms. The RBI has also proposed measures to enhance transparency and fairness for loans where prepayment charges can be levied. Such measures include having a board-approved policy on prepayment charges, disallowance of loan terms that prohibit switching to a different lender, calculating prepayment charges on the outstanding loan and not the total loan amount, and disclosing prepayment charges in the key fact sheet. 

  I welcome the set of proposed measures aimed at enhancing transparency. Borrowers have a right to know what kind of contract they are entering into and should have the freedom to switch lenders. In fact, in a recent paper titled “Does transparency about banks’ lending costs lower firms' borrowing costs? Evidence from India,” forthcoming in the Journal of Accounting and Economics, Nitin Vishen from IIM Bangalore and I show that increased transparency regarding banks’ costs brings down interest rates and also increases lending to small firms.

  However, the issue of banning prepayment charges is not straightforward. The literature on relationship banking argues that small borrowers are likely to obtain credit only when they credibly commit to being with a lender for a minimum period. A paper titled “The Effect of Credit Market Competition on Lending Relationships,” published in the Quarterly Journal of Economics by Professor M A Peterson and Raghuram Rajan, makes the above point.

  The idea is straightforward. Lending to small firms requires banks to incur upfront fixed costs. These costs are necessary as information about these borrowers is not readily available. Bankers, therefore, will have to expend resources to assess creditworthiness. In many cases, bankers cannot recover these upfront costs immediately: Charging the entire cost in one year will likely make the interest rate high and increase the probability of default. High interest rates may also induce borrowers to invest in risky projects. Therefore, banks are forced to spread these charges over multiple years. Thus, banks can recover these upfront expenses only if they are sure that they can retain the borrower for an extended period. Prepayment charges are one way of ensuring that the borrowers stay with the bank longer. 

  Without such charges, ensuring that borrowers stay with the bank becomes difficult, as other banks may have the incentive to free-ride on the efforts of the incumbent banks and lure their borrowers away with lower rates. The outside banks can offer a lower rate as they do not incur the initial screening expenditure. When a borrower moves from an incumbent bank to a new bank before the incumbent bank recovers its expenses, the incumbent bank loses money. 

  A reader may wonder what the problem is if some banks lose money while others gain. Isn’t this normal in any competitive setup? After all, borrowers who switch to a cheaper loan after initially borrowing at higher rates are clearly better off. However, the problem is that the original relationship bank may stop making fresh loans to new small borrowers, uncertain about recovering its upfront fixed costs. Thus, a complete ban on foreclosure charges may dry up credit to small firms and hurt the very same segment that the regulator wants to protect.  

It is not my case that banks should be allowed to charge any amount as prepayment charges. However, regulators can find a middle ground by allowing foreclosure charges to the extent of the unrecovered portion of the fixed costs incurred in screening the borrowers. While arriving at a precise cost estimate for each category of borrowers is difficult, the RBI can start with some broad estimates based on discussions with bankers and figures presented in audited financial statements. However, the final solution lies in making information about small/new firms more easily available to lenders. In such a world, lenders would have  no justification for imposing prepayment charges, even if the law allows it.

 

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  The author teaches finance at Indian School of Business