Applying the Usurious Loans Act of India, 1918, to Financial Institutions to Curb Predatory Lending: A Stitch in Time or Do We Need Nine?
On 15th September 2008 the world woke up to see the collapse of Lehmann Brothers Inc. staring at it ostentatiously through the front page of every newspaper. It was to be the catalyst for a chain of events culminating in what has been generically termed the global financial crisis. While India escaped relatively unscathed by the large scale fluctuations in the global financial markets, the average law student like me is nonetheless faced with a very real prospect of experiencing unemployment first-hand. This bears testimony to the extent of the havoc wrecked by the crisis. However it is possible that the above prospect would have been an undisputed certainty had it not been for the solid regulatory framework (if only when juxtaposed with equivalents in developed countries) governing the financial markets in India. As we steadily resurrect our reputation as one of the Asian tigers, it would perhaps be prudent to approach the future with a view towards blocking the loopholes that remain in the existing regulatory regime. This essay will attempt to address the issue of predatory lending in the context of it being one of the major causes of the crisis, the loopholes in domestic regulatory frameworks of the nations affected that allowed the problem to assume the proportion it eventually did and analyze the idea of extending the Usurious Loans Act of India to the banking industry ( recently proposed by the Reserve Bank of India) to act as a safeguard against the risks associated with predatory lending; to be implemented by the courts in India.
Predatory lending
Predatory lending may be defined as any of a number of fraudulent, deceptive, discriminatory, or unfavorable lending practices. Many of these practices are illegal, while others are legal but not in the best interests of the borrowers. In casual conversation, predatory lending usually means a loan that is bad for the borrower. Common examples of predatory lending include loans with inordinately high rates of interest, the oft-criticized payday loans which charge the annual equivalent of more than 100% for loans in advance of a worker's next paycheck and most significantly, loans which put the borrower at a high risk of default. This brings about the question that considering the decision to borrow money is voluntary and there are plenty of ways in which one can do so, how do these loans arise in the first place? It would be useful at this stage to look at some of the strategies adopted by banks and other financial institutions to sell predatory loans; especially in the housing finance sector of the industry. Negative amortization mortgages allow borrowers to make very low monthly payments, causing the outstanding balance to grow over time rather than get smaller. . Some loans were made to people who could have qualified for conventional mortgages but were steered to sub prime products by brokers seeking the higher-than-normal commissions these loans often paid. Other borrowers with good credit might have been drawn to sub prime loans' low teaser rates. Some apparently used subprime loans to buy second homes or investment properties.
Sub-prime mortgages and the financial crisis
The immediate cause of the financial crisis was the bursting of the bubble in the sub-prime mortgage market. It was similar to the earlier boom and busts that had occurred in a fairly diverse set of markets including railways, telecom, virtual space and tulips. The sequence of events can be traced back to the pronounced fall in interest rates in 2000-01, which led to a growth of high risk or “sub-prime” mortgage loans in the US housing market. US banks offered mortgages to low income people at initial low interest rates. But hidden in the fine print was a shift to higher interest rates that they could ill- afford. The banks knew that many people would not be able to continue payments, but they gambled that rising house prices would cover the cost of defaults. Additionally, the risks of huge losses accruing to the bank were mitigated by packaging these loans into mortgage based securities and luring investors with the possibility of high rates of return. This process was expedited by established rating agencies (examples include Moodys and Standard & Poors ) which rated these securities as good investments. By 2006-07, nearly one-fourth of the US mortgage market was made up of high risk loans, which in numerical terms translates into several millions of borrowers with a very high propensity to default.
The US Paradigm: What should not be done?
A group called Wall Street Watch is out with a report that finds that “Wall Street investment firms, commercial banks, hedge funds, real estate companies and insurance conglomerates made $1.7 billion in political contributions between 1998 and 2008 that were “aimed at undercutting federal regulation” and ultimately “led directly to the current financial collapse.” The report details a dozen key steps to financial meltdown, revealing how industry pressure led to these deregulatory moves and their consequences:
1. Federal regulators refused to block widespread predatory lending practices earlier in this decade, failing to either issue appropriate regulations or even enforce existing ones.
2. Federal bank regulators claimed the power to supersede state consumer protection laws that could have diminished predatory lending and other abusive practices.
3. Federal rules prevent victims of abusive loans from suing firms that bought their loans from the banks that issued the original loan.
4. Fannie Mae and Freddie Mac expanded beyond their traditional scope of business and entered the subprime market, ultimately costing taxpayers hundreds of billions of dollars
5. In 1999, Congress repealed the Glass-Steagall Act, which had prohibited the merger of commercial banking and investment banking.
The Reserve Bank of India: What could be done?
Perhaps illustrating the idea of wisdom being most readily found in hindsight, the Reserve Bank of India recently mooted the idea of extending the Usurious Loans Act of India, 1918, to the banking sector in order to restrict financial institutions from indulging in predatory lending. At present, the Usurious Lending Act is applicable to the unorganized sector, including moneylenders and others. It was enacted with the objective of protecting borrowers from avaricious money lenders who, taking advantage of borrowers (often members of poor agrarian communities) in dire need of money charged excessively high rates of interest. In what may have a widespread impact, sources close to the development said there could be legislation on consumer credit, as is the case in developed countries, which could override all other regulations and directions.
In order to establish whether or not this principle can translate into good policy it is necessary to carry out a brief analysis of the relevant clauses of the Act.
Usurious Loans Act of India, 1918
Following are the provisions of the ULA ( hereinafter the Act) which must be scrutinized in order to form the basis on which the analysis of the RBI proposal must be carried out.
Section 3(1) of the Act provides that in any suit to which this Act applies the Court has reason to believe,
a) that the interest rate is excessive, and
b) that the transaction between the parties was substantially unfair,
The Court may exercise all or any of the following powers:
(i) re-open the transaction take an account between the parties and relieve the debtor of all liability in respect of any excessive interest;
(ii) notwithstanding any agreement purporting to close previous dealings and to create a new obligation re-open any account already taken between them and relive the debtor of all liability in respect of any excessive interest and if anything has been paid or allowed in account in respect of such liability order the creditor to repay any sum which it considers to be repayable in respect thereof;
(iii) set aside either wholly or in part or revise or alter any security given or agreement made in respect of any loan and if the creditor has parted with the security order him to indemnify the debtor in such manner and to such extent as it may deem just.
Following are the explanations to the terms used in Proviso(1) of Section 3 of the Act. Section 3(2) lays down that:
a) In this section “excessive” means in excess of that which the Court deems to be reasonable having regard to the risk incurred as it appeared or must be taken to have appeared to the creditor at the date of the loan.
b) In considering whether interest is excessive under this section the Court shall take into account any amounts charged or paid whether in money or in kind for expenses inquiries fines, bounses, premia, renewals or any other charges and if compound interest is charged the periods at which it is calculated and the total advantage which may reasonably be taken to have been expected from the transaction.
c) In considering the question of risk the Court shall take into account the presence or absence of security and the value thereof the financial condition of the debtor and the result of any previous transaction of the debtor by way of loan so far as the same were known or must be taken to have been known to the creditor.
d) In considering whether a transaction was substantially unfair the Court shall take into account all circumstances materially affecting the relations of the parties at the time of the loan or tending to show that the transaction was unfair, including the necessities or supposed necessities of the debtor at the time of the loan so far as the same were known or must be taken to have been known to the creditor.
Section 3(3) of the Act provides that this section shall apply to any suit whatever its form may be if such suit is substantially one for the recovery of a loan or for the enforcement of any agreement or security in respect of a loan. Proviso (4) of the Section qualifies the above clauses by stating that nothing in this section shall affect the rights of any transferee for value who satisfies the Court that the transfer to him was bona fide and that he had at the time of such transfer no notice of any fact which would have entitled the debtor as against the lender to relief under this section.
Implications
An apparent incompatibility between the context of the enactment of the Act in 1918 and the context of organized institutional lending post 2008, to which it may be extended, is a significant factor that might prove to be an obstacle as far as curbing predatory lending is concerned. Equating money lenders in the unorganized and predominantly rural sector with institutional lenders serves as a good analogy and amply highlights the need to impose a regulatory framework on the latter. It is in the idea that the same (or even similar) legislation can provide a one size fits all solution, that we may find some scope for reconsideration; especially when given that the question of the nature of regulation that is required in the aftermath of the financial meltdown has resulted in several debates but with almost no conclusion or consensus. This argument can be elaborated with reference to the provisions of the Act mentioned above.
The criteria for reopening of transactions as per Section 3 of the Act on judicial order are the presence of excessive interest rates or evidence of the transaction being substantially unfair. As per the explanations to this provision, the consideration for ‘excessive’ is not only the quantum of interest charged but also the risk of default which accrued to the creditor. This would seem to imply that a high rate of interest is justifiable on the grounds of the borrower being in the high risk category; for example the typical member of the sub-prime mortgage market. While sub-prime mortgages per se are relatively rare in India (primarily because of the average Indian’s reluctance to mortgage a sacrosanct home), the point to be considered is that this interpretation of Section 3 prima facie defeats the purpose of protecting vulnerable debtors from the consequences of defaulting on repayment.
Further, the presence or absence of a security and the value of such security are determinants of the level of risk This aspect will surely have to be clarified by way of further guidelines and regulations for a few reasons, the first of which arises out of the discrepancy between the original context of the Act and that of its prospective application. In the case of unorganized lending, the ‘security’ is usually movable or immovable property belonging to the debtor that gets transferred to the creditor in case of non-repayment of the amount due to him. Financial institutions, in order to leverage funds in the short term, bundle these loans backed by collaterals and offer them as attractive investments. The rationale behind this process and the reason for people actually investing in them is the conventional wisdom that only a small minority of debtors actually fails to repay their dues. The financial crisis being a result of a minority of the customers of various banks and financial institutions defaulting on sub prime loans has put the veracity of this line of reasoning under scrutiny. Hence, unlike in the case of an individual lender, the present context arguably leaves the judiciary less equipped to accurately gauge the level of risk on the basis of the purported value of the security. The mortgage based securities market in India is in a nascent stage but expanding fast; the Indian customers’ doubt over the soundness of its moral basis notwithstanding. This issue could be addressed before implementation to broaden the scope of applicability of this Act.
The determinants of substantial unfairness of transaction are circumstances affecting the material relations between the parties and the necessities on part of the debtor as far as known to the creditor. (Though exorbitant rates of interest may, in themselves, be indicators of the transaction being substantially unfair). The notion of necessities of the debtor having a bearing on the fairness of a transaction being accorded legal basis is incongruous with present times; especially when credit card debts, mostly run up to finance purchase of luxuries rather than necessities, are slated to be one of the target areas of the RBI proposal.
In this context it is necessary to mention that what catalyzed the recognition of the need to implement anti-predatory lending measures was a Special Leave Petition filed by four major banks Standard Chartered, Hong Kong and Shanghai Banking Corporation (HSBC), American Express and Citibank to appeal against an order of the National Consumer Disputes Redressal Commission (NCDRC) passed in July 2008, which concluded that charging of interest at rates in excess of 30 per cent for failure of the credit cardholder to make full payment on the due date is an “unfair trade practice”. However Section 21(A) of the Banking Regulation Act specifies that rates of interest charged by banking companies are not subject of scrutiny by courts and hence no transaction can be opened on the basis of excessive charges. Responding to this issue the RBI had said functions exercised by it in relation to credit cards are only regulatory in nature and the consumer forum would be entitled to adjudicate on the interest rates charged by banks amounting to unfair trade practice under the Consumer Protection Act, 1986.
Re-iterating the need for judicial guidelines, the SLP in question brings into play the conflict between concomitant needs to prevent victimization of innocent consumers on one hand and at the same time to let market based safeguards curb consumer profligacy.
Conclusion
Thus, some issues still need to be resolved before India has a holistic regulatory framework to curb predatory lending. As mentioned, factors like quantum of risk to the creditor, securitization and consumer profligacy needs both judicial guidelines backed by executive competence in order to ensure that the financial markets of India enjoy optimal growth without the risk of a meltdown. While the Usurious Loans Act may well have been conceived as only a model legislation by the RBI in its proposal, the moot point remains that whether the Act is applied to financial institutions in an amended form or whether a separate legislation is enacted, the caveats mentioned above will have to be carefully removed for such legislation to achieve its objectives
