Interest on Interest Case Can Open a Pandora’s Box. Govt and SC Need to Be Careful

Late last week the central government told the Supreme Court that it was ready to waive off the interest on interest (i.e. compound interest) on loans of up to Rs 2 crore during the moratorium period of six months between March and August 2020.

In an affidavit submitted to the Court, the government said: “The government… has decided that the relief on waiver of compound interest [interest on interest] during the six month moratorium period shall be limited to the most vulnerable category of borrowers. This category of borrowers, in whose case, the compounding of interest will be waived, will be MSME loans and personal loans up to Rs 2 crore.”

This response was as a part of the matter of Gajendra Sharma versus the Union of India.

The Reserve Bank of India refers to retail loans as personal loans. Hence, the types of loans which would get a waiver of compound interest for a period of six months of the moratorium are home loans, vehicle loans, education loans, consumer durables loans, credit card outstandings, normal personal loans and MSME loans. This benefit will be available to all borrowers who have taken loans of up to Rs 2 crore, irrespective of whether they opted for the moratorium or not.

Before offering my views on this, let’s first try and understand the concept of compound interest or interest on interest.

Let’s consider a home loan of Rs 2 crore to be repaid over a period of 20 years (or 240 months) at the rate of 8% per year. Let’s further assume that the loan was taken during the month of March and was immediately put under a moratorium (the need to make this assumption will soon become clear).

The moratorium lasted six months. The simple interest on the loan of Rs 2 crore amounts to Rs 8 lakh (8% of Rs 2 crore divided by 2). This is not how banks operate. They calculate interest on a monthly basis. At 8% per year, the monthly interest works out to 0.67% (8% divided by 12). The interest for the first month works out to Rs 1.33 lakh (0.67% of Rs 2 crore).

Since the loan is under a moratorium and is not being repaid, this interest is added to the loan amount outstanding of Rs 2 crore.
Hence, the loan amount outstanding at the end of the first month is Rs 2.013 crore (Rs 2 crore + Rs 1.33 lakh). In the second month, the interest is calculated on this amount and it works out to Rs 1.34 lakh (0.67% of Rs 2.013 crore).

In this case, we calculate interest on the original outstanding amount of Rs 2 crore. We also calculate the interest on Rs 1.33 lakh, the interest outstanding at the point of the first month, which has become a part of the loan outstanding.

At the end of the second month, the loan amount outstanding is Rs 2.027 crore (Rs 2.013 crore + Rs 1.34 lakh).  This happens every month, over the period of six months, as can be seen in the following table.

Interest on interest

 

Source: Author calculations.

At the end of six months, we end up with a loan outstanding of Rs 2.081 crore. This is Rs 8.134 lakh more than the initial loan outstanding of Rs 2 crore. As mentioned initially, the simple interest on Rs 2 crore at 8% for a period of six months works out to Rs 8 lakh.

Hence, the interest on interest works out to Rs 13,452 (Rs 8.134 lakh minus Rs 8 lakh).

What was the point behind doing all this math and trying to explain compound interest here?

The maximum amount on which the government is ready to waive off interest on interest is Rs 2 crore. For the kinds of loan under consideration Rs 2 crore outstanding is likely to be either on a home loan or a SME loan. In case of an SME loan, the interest rate will probably be more than 8%.

On a home loan of Rs 2 crore at 8% with 240 instalments (20 years) left to pay, the interest on interest for a period of six months works out close to Rs 13,500. The point is if an individual can afford to take on a loan of Rs 2 crore at 8% interest and pay an EMI of Rs 1.67 lakh, he can also pay an interest on interest of Rs 13,452. In case of an SME loan, the interest on interest would be higher than Rs 13,432, but it wouldn’t be an unaffordable amount. So, what’s the point of doing this?

An estimate made by Kotak Institutional Equities suggests that this move is likely to cost the government around Rs 8,000 crore (Rs 5,000 crore for banks + Rs 3,000 crore for non-banking finance companies (NBFCs)). While Rs 8,000 crore isn’t exactly small change but it’s not a very large amount for the central government.

But that’s not the point here. This move and the Supreme Court dabbling in this case will end up opening a pandora’s box. Let’s take a look at this pointwise.

1) Media reports suggest that the Supreme Court is not happy with the government’s offer to waive off interest on interest. A report on NDTV.com suggests that waiving interest on interest on loans of up to Rs 2 crore “was not satisfactory and asked for a do-over in a week”.

As the report points out: “The affidavit “fails to deal with several issues raised by petitioners”, the court said. The central government has been asked to consider the concerns of the real estate and power producers in fresh affidavits.” Clearly, neither the Court nor the companies are happy with interest on interest of loans of up to Rs 2 crore being waived off.
By offering to waive off interest on interest the government is trying to meet the Court halfway. Also, it is important that the Court along with the government realise that they are interfering with the process of interest setting by banks, something that largely works well.

What is interest at the end of the day? Interest is the price of money. By taking on this case, the Supreme Court has essentially gotten into deciding the price of money. When a bank pays an interest to a deposit holder, it is basically compensating the deposit holder for not spending the money immediately and saving it. This saving is then lent out to anyone who needs the money. This is how the financial intermediation process works.

The government and the Court are both trying to fiddle around with the price of money and that is not a good thing. Today one set of companies have approached the Court to decide on the price of money, tomorrow another set might do the same.

2) The companies are clearly not happy with the interest on interest waiver offer primarily because their loans are greater than Rs 2 crore and they want more. This is hardly surprising.

In the affidavit the government has said: “If the government were to consider waiving interest on all the loan and advances to all classes and categories of borrowers corresponding to the six-month period for which the moratorium was made available under the relevant RBI circulars, the estimated amount is Rs 6 lakh crore.”

To this, the response of the real estate lobby CREDAI was: “A lot of facts and figures in the government’s affidavit are without any basis and the finance ministry’s estimate that waiving off interest on loans to every category would cost banks Rs 6 lakh crore is wrong.”

It is easy to verify this with a simple back of the envelope calculation. As of March 2020, the non-food credit of banks was at Rs 103.2 lakh crore. The banks give loans to Food Corporation of India and other state procurement agencies to buy rice and wheat directly from farmers. Once these loans are subtracted from the overall loans of banks, what is left is non-food credit.

The weighted average lending rate of scheduled commercial banks was at 10% in March 2020 (This is publicly available data). Just the simple interest on non-food credit for six months works out to Rs 5.16 lakh crore (10% of Rs 103.2 lakh crore divided by 2).

Over and above this, there is lending carried out by NBFCs, on which interest on interest will have to be waived off as well. Also, once we take compound interest into account, Rs 6 lakh crore is clearly not a wrong figure as CREDAI wants us to believe.

The weighted average lending interest rate has fallen a little since March. In August, the weighted average lending rate of scheduled commercial banks was at 9.65%. Even after taking this into account, Rs 6 lakh crore is not an unrealistic number at all.  The government and the SC need to be careful regarding any demands of lowering interest rates on loans.

3) The real estate companies have an incentive in getting as much from the Court as possible. Financially, many of them are overleveraged. In fact, the former RBI Governor Urjit Patel in his book Overdraft refers to them as ‘living dead’ borrowers or zombies. And a living dead borrower will go as far as possible to survive at the cost of others. Any new bailout allows them to survive in order to die another day. Also, it allows them to continue not cutting home prices.

Clearly, companies want some reworking on the interest front (the interest on interest for a period of six months isn’t going to amount to much). But this raises a few fundamental questions.

If the Court and the government get around to cutting interest rates on loans, they will be deciding on the price of money. If they do it this one time, they are basically giving Indian capitalists the idea that they can approach the courts and challenge the price of money being charged. What stops it from happening over and over again?

While the government does try and influence the interest rates charged on loans by public sector banks, it can’t do so when it comes to private banks, which now form around 35% of the market when it comes to loans. Nevertheless, if any decision lowering interest rates is made they will end up influencing the price of money of private banks as well. And that isn’t a good thing. The last thing you want in a period of economic contraction is to try and disturb the banking system in any way.

4) Also, any interest rate waiver or reduction will give political parties ideas, like waiving off agricultural loans they can waive off other loans as well. And that can’t be a good thing for the stability of the Indian banking system.

5) If the government really wants to help businesses it can do so by reforming the goods and services tax and making it more user friendly. That will go a much longer way in helping the Indian economy without disturbing a process which currently works well. Any fiddling around with interest rates is largely going to help only zombie companies.

As Urjit Patel writes in Overdraft: “Sowing disorder by confusing issues is a tried-and-trusted, distressingly often successful routine by which stakeholders, official and private, plant the seeds of policy/regulation reversal in India.” This time is no different. Hence, both the government and the Supreme Court need to be very careful in how they deal with this. It is ultimately, the hard earned money of millions of Indians which is at stake. The Indian banking system is one of the few systems which people continue to trust. You wouldn’t want that to break down.

 

A Primer on Bank Interest Rates for Real Estate Companies, Lawyers, Judges, Government and Everyone Else

The Supreme Court is currently hearing the loan moratorium case. Arguments have been made from different sides, on whether banks should charge an interest on loans during the moratorium and if an interest should be then charged on that interest.

I wanted to discuss a few arguments being offered by lawyers who are representing borrowers of different kinds in the Supreme Court. Either their understanding of interest rates is weak, or even if they do understand, they are just ignoring that understanding in order to make a powerful argument before the Supreme Court.

Let’s look at the issue pointwise. Also, this piece is for anyone who really wants to understand how interest rates really work. Alternatively, I could have headlined this piece, Everything You Ever Wanted to Know About Interest Rates But were Afraid to Ask.

1) Appearing for the real estate sector, Senior Advocate C A Sundaram told a bench of Justices Ashok Bhushan, R S Reddy and M R Shah: “Even if the interest is not waived, then it must be reduced to the rate at which banks are paying interest on deposits.”

What does this mean? Let’s say a real estate company has taken a loan of Rs 100 crore from a bank. On this it pays an interest of 10% per year. For the period of the moratorium the company doesn’t pay the interest on the loan. At the end of six months, the interest outstanding on the loan is Rs 5 crore (10% of Rs 100 crore for a period of six months). In the normal scheme of things this outstanding interest needs to be added to Rs 100 crore and the loan the builder now needs to repay Rs 105 crore. Of course, in the process of repaying this loan amount, the company will end up paying an interest on interest. If it wants to avoid doing that it simply needs to pay the outstanding interest of Rs 5 crore once the moratorium ends and continue repaying the original loan.

What Advocate Sundaram told the Supreme Court is that even if the interest on the loan during the moratorium is not waived, the interest rate charged on it should be lower and should be equal to the interest rate that banks are paying on their deposits.

The question of not charging an interest rate on loans during moratorium is totally out of question. Banks raise deposits by paying a rate of interest on it. It is these deposits they give out as loans. If they don’t charge an interest on their loans, how will they pay interest on their deposits?

Bank deposits remain the most popular form of saving for individuals. Imagine the social and financial disruption something like this would create.

Even the point about banks charging an interest rate during the moratorium which is equal to the interest rate they are paying on their deposits, is problematic. Other than paying an interest rate on deposits, banks have all kinds of other expenditures. They need to pay salaries to employees and off-role staff, rents for the offices and branches they operate out of, bear the cost of insuring deposits and also take into account, the loan defaults that are happening.

If the banks charge an interest rate on loans equal to the interest rate they pay on deposits, how are they supposed to pay for all the costs highlighted above?

2) More than this, I think there is a bigger problem with Senior Advocate Sundaram’s argument. Allow me to explain. Interest on money is basically the price of money. When a bank pays an interest to a deposit holder, he is basically compensating the deposit holder for not spending the money immediately and saving it. This saving is then lent out to anyone who needs the money. This is how the financial intermediation business works.

If real estate companies could today ask the courts to decide on the bank’s price of money, the banks could do something similar tomorrow. They could approach the courts with the argument that real estate companies need to reduce home prices, in the effort to sell more units, so that they are able to repay all the money they have borrowed from banks.

If courts can decide on how banks should carry out their pricing, they can also decide on how real estate companies should carry out their pricing. This is something that needs to be kept in mind.

3) This is a slightly different point, which might seem to have nothing to do with interest rates, but it does. The real estate industry is in dire straits and hence, wants the government, Reserve Bank of India (RBI) and the Supreme Court, to help. (I am going beyond what Advocate Sundaram told the Court).

In fact, banks and non-banking finance companies, have already been allowed to restructure builder loans. Former RBI governor Urjit Patel refers to the commercial real-estate-sector as the living dead borrowers in his book Overdraft.

The real estate sector had a great time between 2002 and 2013, for more than a decade, when they really raked in the moolah.

While they did this, they obviously kept the after-tax profits with themselves and they didn’t share it with anyone else. So, why should they be supported now? Why should their losses be socialised? And if losses of real estate sector are socialised, where does the system stop? This is a question well worth asking.

If these losses are socialised, the banks will try making up for it through other ways. This would mean lower interest rates on deposits than would otherwise have been the case. This would also mean higher interest rates on loans than would otherwise have been the case. There is no free lunch in economics.

4) Senior Advocate Rajiv Datta said that banks should not take the moratorium as a default period to charge interest on interest to individual borrowers, including those repaying home loans. As he said: “Profiteering at the cost of individual borrowers during a pandemic is like Shylock seeking his pound of flesh. Individual borrowers were not defaulting.”

While I have no love-lost for bankers, but generations of bankers have had to suffer thanks to the way the William Shakespeare portrayed a Jewish money lender in his play The Merchant of Venice.

The question is why is everyone so concerned only about the borrowers. What about the savers? The average fixed deposit rate is now down to 6%. This, when the rate of inflation is close to 7%. The savers are already losing out. Why should they lose more?

5) Another argument was put forward by Senior Advocate Sanjay Hegde, where he said that banks never passed the benefit of lower repo rate to consumers in the whole of 2019 to garner bigger profits. “When there is a pandemic, they should not think of profiteering and pass on the benefits granted by the RBI to borrowers by lowering the interest rate on loans,” he said.

This is a fundamental mistake that many people make where they assume a one to one relationship between the repo rate and loan interest rates. Repo rate is the interest rate at which the RBI lends money to banks. The idea in the heads of people and often portrayed in the media is that the repo rate is coming down and so, should loan interest rates, at the same pace.

In December 2018, the repo rate was at 6.5%. Since then it has been reduced to 4%. There has been a cut of 250 basis points. One basis point is one hundredth of a percentage. During the same period, the weighted average lending rate on outstanding loans has fallen from 10.35% to 9.71%, a fall of a mere 64 basis points.

So is Senior Advocate Hegde right in the argument he is making? Not at all. As I said earlier, the link between the repo rate and the lending rate is not one to one. The reason for that is very simple. Banks raise deposits and lend that money out as loans. For lending interest rates to fall, the deposit interest rates need to fall.

The weighted average deposit interest rates since December 2018 have fallen from 6.87% to 5.96% or a fall of 91 basis points. We see that even the deposit interest rates do not share a one to one relationship with the repo rate.

Why is that the case? If a depositor invested in a deposit at 8% interest three years back, he continues to be paid that 8% interest, even when the repo rate is falling. Further, even though banks reduce the interest rate they pay on new fixed deposits, they cannot do so on the older fixed deposits. The fixed deposit interest rates are fixed and that is why they are called fixed deposits.

If the repo rate and the fixed deposit interest rates need to have a one to one relationship, meaning a 25 basis points cut in the repo rate leads to a 25 basis points cut in deposit rates, which translates into a 25 basis points cut into lending rates, then banks need to offer variable interest rate deposits and not fixed deposits. Again, that is a recipe for a social disruption.

If we look at fresh loans given by banks, the interest charged on them has fallen from 9.79% in December 2018 to around 8.52%, a fall of 127 basis points, which is much higher than the overall fall of just 64 basis points. This is primarily because the interest rate on fresh fixed deposits has fallen faster than the interest rates on fixed deposits as a whole.

This still leaves the question why has the overall lending rate fallen by 64 basis points when the overall deposit rate has fallen by 91 basis points. One reason lies in the fact that banks have a massive amount of bad loans and they are just trying to increase the spread between the interest they charge on their loans and the interest that they pay on their deposits, by not cutting the lending rate as fast as the deposit rate.

This will mean a higher profit, which can compensate for bad loans to some extent. Over and above this, there is some profiteering as well. But the situation is nowhere as bad as the lawyers are making out to be.

The reason for that is simple. There is a lot of competition in banking and if a particular bank tries to earn excessive profits, a competitor can easily challenge those profits by charging a slightly lower rate of interest and getting some of the business.

To conclude, allowing banks to set their own interest rates is at the heart of a successful banking business. And no one should be allowed to mess around with that. Also, for the umpteenth time, interest rates are not just about the repo rate.