No Collateral, No Dreams? Why India Shouldn't Abandon Unsecured Loans
The Indian financial sector is witnessing a growing shift towards secured loans, as banks and NBFCs pivot away from unsecured credit segments. This shift has been accelerated by the Reserve Bank of India's (RBI) decision to increase risk weights on unsecured loans amid rising delinquencies. Digital lenders are increasingly establishing physical branches and expanding their on-ground presence for collateral verification. Meanwhile, the growth in bank credit to NBFCs—due to their predominance in unsecured loans—has slowed significantly, dropping from 18% to 6% over the past year.
The Cost of Financial Exclusion
However, a secured-only lending environment poses risks of financial marginalization. Such a shift could exclude vital segments of our economy - from first-time entrepreneurs and small business owners to women entrepreneurs and skilled professionals starting their ventures. These segments lack traditional collateral such as gold, houses, vehicles, and therefore rely on unsecured credit to fund their aspirations and contribute to the economy. Doing away with unsecured loans entirely risks hampering social mobility and innovation at the grassroots level.
Credit growth itself is not the problem—credit growth at unsustainable rates is.
Understanding the Root Cause
As we have seen in previous posts*, the high default rates in unsecured lending stem from a fundamental mismatch between interest rates and economic growth. It comes down to the prolonged high interest rate environment in the country, with credit servicing made difficult by falling GDP growth rates.
Ideally, lending rates should maintain a sustainable spread on top of the RBI's base (repo) rate. During periods of robust GDP growth, this band can widen as businesses generate higher revenues. However, during downturns or slower growth, the band must necessarily contract to align with the economy's incremental revenue-generating capacity. Allowing the interest rate spread to remain stretched in a low-growth environment inevitably leads to defaults.
What the Numbers Say
To understand this point better, we should realize that only if the GDP expands, can new (and expanding) businesses generate new revenue from the economy. Higher the GDP expansion, the easier it is for such growing businesses to generate incremental revenue. Let us try to quantify this through a simple calculation:
What is the maximum interest rate at which these businesses can service their capital/opex loans? This is given by the maximum rate for which
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(GDP expansion – commercial_credit × rate) > 0
Working with the current values:
$151 billion - ($1.4 trillion × rate) > 0
Therefore, rate < 10.8%
From this simple optimization model, we find that the (maximum) sustainable average interest rate is approximately 10.8% across all commercial lending.
The Call for Interest Rate Cuts
While further analysis is needed to determine the appropriate rate band for secured versus unsecured lending, the takeaway from this calculation is clear: credit growth itself is not the problem—credit growth at unsustainable rates is. To address rising defaults and ensure financial inclusion, the RBI must consider interest rate cuts. Lower rates would not only ease the burden on borrowers but also catalyze GDP growth, allowing businesses to generate incremental revenues and thrive.
As India aims for inclusive growth, we must strike the right balance: supporting credit expansion while ensuring it happens at rates that the economy can sustain.