Recent move by the Reserve Bank of India, putting a stop to the so called “Zero Interest schemes by Banks was a very welcome move. Just as one was feeling happy reading this, clearly a step towards greater transparency and a good progressive measure towards increased consumer protection, came the dampener a few days later, that RBI’s announcement could possible apply only to Banks and not to NBFCs (Non-Banking Financial Companies) meaning that all the Finance Companies can continue to offer Zero Interest rates.
Why Zero Interest schemes are really not Zero Interest? Most of the lenders charge a significant amount as “processing charges”. Actual processing charges may be insignificant and charging a large processing fee on the “buyer/borrower” is nothing but an upfront interest collection. Such Zero Interest schemes are generally operated in respect of “Durables” and run for a period of just about a year (12 Equated Monthly Installments ) or in some cases could be a bit longer period. On a Consumer durable of Rs. 25,000, processing fee of Rs. 4,000 is 16% PA and the entire processing fee is collected upfront. Calling interest as “processing fees” does not change the fact that there is an underlying financial cost.
There is need for transparency. Precisely for this, that is, for protection of all types of consumers, that the Government had progressively brought in various measures like the compulsory need to have an all-inclusive MRP (Maximum Retail price), the need to clearly mention the weight of contents on the label etc. Old timers may recall a period when the packages used to carry “Price…..Rs…” plus local taxes. This used to give ample scope for misuse.
Government also had enacted a Consumer protection Act, 1986 providing protection to consumers on various aspects, like price, quantity and quality.
A complicated law or a law which draws oblique references or a law which gives rise to varying interpretations or even a law which is not laid out in simple and clear terms become just laws in the books and do not really contribute to ensure what it was enacted to achieve.
People availing of Banking and financial services are in fact covered by the Consumer Protection Act, 1986. The Act does talk of shortfall in services and misleading statements, which can be a cause for “complaint”, but let us look at some aspects in the Financial services Industry which are misleading without appearing to be so. The players in financial services Industry, at least many of them if not all of them, mislead borrowers /lenders in very subtle ways. Let us examine some aspects.
Companies quoting Simple interest rates-termed as Yields
Companies which take in “deposits” from the public talk of Annualized yields. What is this yield? A, Rs. 1,000, 5 years cumulative deposit on which, a 12% PA interest is payable, would be Rs. 1762 at the end of 5 years. Companies quote it as yield of 15.24% per annum. People who have some basic understanding of finance and interest methodologies know that this is nothing but “simple interest”. Compare this with an honest Company which has very similar terms but announces that they pay on a 5 year cumulative deposit an annualized interest rate of 12% at yearly rests. There is absolutely no difference at all in the terms but the consumers would gravitate towards the 15.24% interest after all a 15.24% interest is better than a 12% interest, never understanding the simple Interest Vs. Compound interest aspects.
Interest accumulations at monthly Vs. Quarterly vs. Annual rests-Compounded
We all know that Interest at monthly or quarterly or yearly rests make a difference to the overall returns. A 12% coupon rate at monthly rests is 12.68% on an annualized basis, the same at quarterly rests is 12.55% and at annual rests is 12%.
When a retail depositor compares, he has to be given a logical comparison. The attempt is always to give out a comparison computed on different assumptions. To evade the long arm of the regulatory authorities, the Companies which come out with advertisements always have a footnote or fine print where so much information is loaded that one finds it difficult to make the critical ones from the non-critical ones, the result is nothing gets read by the depositor.
Flat rate Vs. Reduced balance method
Just as Companies beef up the rates of interest when they borrow to make it seem attractive to the depositors, they take exactly the opposite tack when it comes to lending. Obviously when lending, the Financial services Companies have to communicate how attractive their lending rates are Vis a Vis the Competitors. Lower the interest rate, real or illusory, better for the finance companies to attract borrowers. A very common method is the bold, headline grabbing interest rates, which come with a footnote or qualification, “flat rate”. “Flat rate” is nothing but charge of interest on the original amount borrowed, ignoring the EMIs (Equated monthly installments) paid on a monthly basis. The normal and the correct method is “reducing balance method” would obviously be much higher. Such lending is resorted to on “Cars” and “vehicles”. To illustrate the disparity, a so called flat rate of 7% for a loan taken for 5 years on which repayments are made on a monthly basis would be a little over 11% under the “reducing balance method”. When Companies advertise “Flat rates”, what incentive would be there for other Companies/competitors to be transparent and honest, after all, it would cost them business.
In some of the countries like United States of America, there is a requirement to quote the rate only in APP or Annual Percentage points or APR (Annual percentage rate), which is nothing but expressing the rate of interest at annual rests basis. The idea is to make it really comparable.
Consumer protection in the financial services does not require a great enactment; all it requires is making standardization a compulsion. Standard terms and methodologies can be defined to make the financial services company express their cost as an equivalent of MRP (Maximum Retail Price), or in this case we can evolve something called a Maximum Interest Cost Percentage-MICP.
We all know that even stalwarts and seasoned finance professionals got hoodwinked a few years back on so called “esoteric” derivatives by top class and reputed Banks in the Country. The unknowing and sometime gullible public definitely requires protection and transparency and standardization can be starting points towards that.
Chartered acountant with Industrial and consulting experience
and visiting faculty in SJCBA, Bangalore