RBI’s Proposal and Intent
- The Reserve Bank of India (RBI) has proposed banning foreclosure or prepayment charges on loans to small firms (up to ₹7.5 crore).
- The move is aimed at curbing “divergent practices” that lead to customer grievances and restrict borrowers from switching lenders for better rates.
- The RBI also plans to enhance transparency by mandating:
- A board-approved policy on prepayment charges.
- Prohibition of clauses restricting lender switching.
- Prepayment charge calculations on outstanding amounts only.
- Disclosure of these charges in the key fact sheet.
Why Transparency Is Welcome
- Transparency empowers borrowers and allows informed decision-making.
- Recent research (by Nitin Vishen and Prasanna Tantri) shows that greater transparency lowers borrowing costs and boosts lending to small firms.
- Disclosure of costs helps reduce exploitation and improves credit market efficiency.
The Complexities of Banning Prepayment Charges
- Relationship banking theory suggests that small borrowers often gain access to credit by committing to a lender for a minimum duration.
- Banks incur upfront fixed costs (due diligence, credit assessment), which are recovered over multiple years.
- Without prepayment charges, borrowers may switch lenders before banks recover these costs, leading to losses.
- “Free-riding” issue: New banks might lure customers with lower rates without having invested in the initial screening.
Potential Adverse Effects
- If banks cannot recover upfront costs, they may reduce lending to small or risky borrowers.
- Ironically, this could hurt credit access for small firms, the very sector the RBI aims to protect.
- Banks may also respond by charging higher interest rates upfront, potentially increasing defaults or risky borrower behavior.
A Middle-Ground Solution
- Instead of a blanket ban, regulators could:
- Allow prepayment charges only to the extent of unrecovered upfront costs.
- Set broad estimates for these costs based on financial statements and discussions with lenders.
- This would balance borrower freedom with lender sustainability.
The Long-Term Solution
- The ultimate fix lies in making information on small/new firms more accessible.
- With transparent data availability, lenders won’t need to impose prepayment charges, as switching will not cause unrecovered cost losses.
While the RBI’s efforts to enhance transparency and borrower choice are commendable, a complete ban on prepayment charges may reduce credit availability for small businesses. A nuanced approach, balancing fair costs and free market movement, is essential to foster healthy credit growth for small enterprises.
Source: BS
