Why pre-payment penalty should go

The Reserve Bank of India is reportedly engaged in active discussion with commercial banks to try and bring within reasonable limits, if not stop entirely, the practice of banks charging a hefty penalty, often going up to as high as 2 per cent or more of outstandings, from borrowers seeking to take their housing loans elsewhere.

While this is clearly the right thing to do, it is about time RBI got moving a little faster.

It is now clear that in at least one other instance, microfinance, many of the sector's present troubles would have been avoided had RBI discharged its regulatory role with greater speed.

. . .

It is also a bit disingenuous in letting it be known that we do not approve these things and players are advised to change their ways, but leaving matters there indefinitely.

The attempt to use moral suasion can be produced as evidence to counter the charge of inaction but if no firm action is eventually taken, then the brazen can get away with continuing to do what they want even though everybody agrees that this is not the right thing to do.

Commercial banking is already a restricted market in the sense that you need a licence to run a bank and accept deposits, something that you do not need if you were to, say, manufacture a motor car.

If on top of that the incumbent players engage in something which is clearly anti-competitive, then it is the customer who gets the short end of the stick and the overall efficiency of the sector suffers.

The fact that the Competition Commission does not think the practice is anti-competitive says more about the Commission than the wisdom of its reasoning.

At a time when there is mobile number portability and health insurance portability is round the corner, it is absurd that in a sphere which attracts the most amount of the lifelong savings of a middle class family, housing, restrictive market practices are allowed to continue.

. . .

Like mobile telecom service providers and health insurance firms, banks have to live by the quality of their service and not anti-competitive practices.

If State Bank of India offering teaser rates has not caused HDFC to go out of business, there must be a reason why people are willing to pay more to still develop a long-term relationship with HDFC.

Two reasons are cited by banks for charging penal rates for pre-payment of a housing loan by a borrower seeking to change bankers.

One is the original lender loses on the processing expenses that it had incurred on sanctioning the loan.

. . .

This is fair and refund of the processing cost should certainly be in order in case a loan is prepaid soon after its disbursal.

But this is a finite cost -- how many man hours do you really need to process a loan, what with technology reducing costs? -- which is independently computable and can be levied according to norms laid down by the regulator.

But it is likely to be far lower than the Rs 40,000 that a borrower will have to pay if she pre-pays an outstanding of Rs 20 lakhs (Rs 2 million) which can be taken to be a rough median figure.

. . .

The second argument holds even less water.

Banks claim that they will land in asset-liability mismatch if a long-term borrower, say someone who has taken a 20-year housing loan, walks away as the bank will lose the asset against which it will have created a liability of similar tenure.

The fact is, long-term lending by commercial banks which live mostly by taking short-term deposits, invariably leads to asset-liability mismatch.

Banks are living with this and the regulator is allowing them to do so.

. . .

It is for this reason that earlier there were term lending agencies in the shape of development financial institutions which lent long term and banks lent at most medium term.

The situation will change when there is an active long-term debt market where pension funds can park their corpuses and banks float paper to access those resources.

There is one other reason why levying of exorbitant pre-payment penalties should be outlawed.

. . .

This practice makes for a lethal combination with another unhealthy practice -- teaser rates.

The current position is that a bank can induce a borrower to take a long-term housing loan by offering a teaser rate and then slap a sharp pre-payment penalty on anyone seeking to go elsewhere later when interest rates start going up.

Both of these practices should be disallowed.

. . .

Instead, RBI is allowing both to prevail even while making noises that it does not approve of them.

In fact, the banking regulator can go a step further and take some innovative measures that will give retail customers of real estate a better deal and, what is systemically more important, spread a superior culture among real estate companies that makes for better health in the sector.

Realty firms that give their ordinary customers a transparent and fair deal are likely to have greater integrity, be sounder and make for a more stable industry.

. . .

RBI can well say that its primary job is to worry about the banking sector and not the real estate sector, but it does have a developmental role and can take a legitimate interest in the health of an asset class with a long life.

It can, for example, tell banks that they should encourage realty firms that borrow from them to ensure two sound practices.

One, mention the carpet area along with whatever else they want to like super built-up area while selling an apartment.

Two, offer a warranty for a reasonable period, indemnifying the buyer against manufacturing defects.

This will be as revolutionary as feasible.