“Hello, Ms Fatima. May I have a moment of your time?” I am asked deferentially. The call is from my bank, urging me to take a short-term loan for personal expenses. Anyone with a steady inflow in their bank account has received a similar call at one time or another. The salesperson makes it sound like an easy-peasy lottery ticket and on their websites, banks paint a picture of walking into a branch with minimal documentation and being able to access the required amount. The reality is much more complicated.
The Government of Pakistan, as a sovereign institution, is considered the most reliable borrower, which is why it owns 66% of outstanding loans, according to data published by the State Bank of Pakistan (SBP). Consumer financing, which includes housing and auto finance, credit card debt, loans for consumer durables and personal loans, makes up a mere three percent of the outstanding debt. As for personal loans, amounts borrowed for any random purpose, such as renovating a house or throwing an elaborate wedding, stand at a mere 0.8% of the total outstanding debt by commercial financial institutions. Personal loan facilities include running finance and revolving credit to customers which are more attuned to small businesses.
According to a commercial banker, “Apart from the government, most of the lending is focused towards corporates or other organisations. Individuals are offered loans in the form of auto-financing or are geared towards small businesses. Banks do not receive a high volume of applications for personal loans, nor do they aggressively seek such loans.” He adds that it is a chicken and egg situation in so far that “maybe banks are not encouraging people to take out personal loans and thus demand is low. Or, demand is low because there is little interest in that segment; organisations are easy to track whereas the default risk is much higher for individuals. There are many cases of fraud where a person takes a loan and runs away.”
Yet, SBP data indicates that the infection rate (proportion of non-performing loans) of personal loans is about five percent. In other words, about five in 100 people default, which is lower than the default rate in the corporate sector which hovers at nine percent. The discrepancy between what bankers say and the data suggest two possibilities. There may be an inherent bias against the ability of individuals to pay back or the due diligence carried out by banks on personal loans is more thorough than the process that corporate clients are subjected to.
Different banks offer different minimum and maximum amounts as personal loans, with varying tenures. Based on SBP guidelines, the maximum amount that can be offered under the heading of a personal loan is five million rupees for a tenure not exceeding five years. However, the SBP allows this period to extend up to seven years if the loan is for educational purposes and disbursements are made directly to the educational institution.
However, the actual amount and duration of a loan can be shorter. For example, Allied Bank offers amounts as low as Rs 30,000 for a year. According to information provided on their websites, commercial banks such as Bank Alfalah, Muslim Commercial Bank (MCB) and Silk Bank do not require collateral for a personal loan although in some cases financial institutions may require personal guarantees tied to assets such as a car or land, depending on the amount loaned.
Before disbursing a personal loan, a complete assessment is carried out based on income flows or salary slips and day-to-day expenses. Although there is no collateral, banks require personal guarantees to which they try to attach assets that can be repossessed in case of default. Witnesses, references and physical visits to the house or place of employment is part of the verification process. “There are oodles of documentation,” says a source in an Islamic bank. “There are partnership agreements or you may even be asked to buy stocks in an affiliated fund.”
Taking legal action against defaulting personal loans is not viable because of the volume of people that refuse to pay; in other words, it is not financially feasible to tie up resources for relatively small amounts. Furthermore, a lot of legwork is required from the bank when it comes to extending a small loan with a fairly high risk (despite the in-depth assessment process) because, as one banker points out, people lie about being bankrupt and refuse to pay. What is in it for the banks? Answer: the high interest rate that is earned.
“Imagine giving Rs 300,000 to four million people. The interest earned on this amount is significant because of the high rate charged compared to the low rates extended to a company,” says another banker. “An organisation can access rates as low as Kibor plus two percent, whereas an individual is charged Kibor plus 12%.” According to HBL’s schedule of charges, the annual rate goes up to 38% per annum. MCB lists rates as high as Kibor plus 14 to 16% (Kibor at the time of publication is over 15%).
The high rate of interest makes the legwork and risk worthwhile for a bank. But what about Islamic banks, where interest is haram? In this case, Sharia-based financing is based more on sale and purchase contracts, the difference between which yields a profit for the bank while fulfilling the needs of the customer.
An Islamic banker explains this through the example of auto financing. If a consumer wants to buy a car, an Islamic bank does not give a loan — it applies the diminishing Musharakah principle. The SBP explains diminishing Musharakah as “a form of joint ownership in an asset in which any of the joint owners undertakes/promises to buy the ownership share of the other joint owner(s) gradually until the ownership of the joint asset or property is transferred to the purchasing joint owner.”
Legal mumbo-jumbo aside, let’s understand this through a hypothetical situation. Ali wants to purchase a Suzuki Alto which costs Rs 1.7 million. An Islamic bank will purchase the car for Ali and ‘rent’ it to him for a lump sum of two million rupees, which Ali will pay in instalments.
From the get-go, the car belongs partly to the bank and partly to Ali. After the payment of each instalment (the fee for the service provided), Ali’s ownership of the car increases. When the last instalment is cleared, the Alto belongs to Ali. Since the car is ‘rented’ (known as Ijarah), if the car is stolen, Ali is not liable for the remaining amount.
Personal financing through Islamic banks uses a similar concept but with different modalities. In essence, the bank purchases the good or service the customer needs and then sells it back to the customer. The difference between the sale and purchase price is the bank’s profit for providing the facility to the customer.
For example, Dubai Islamic Bank uses the concept of Musawamah, whereby after obtaining the title and possession of the goods, the bank sells them to the customer on a deferred payment basis. The essence is the same, the nuances are different.
Customers looking for personal loans can shop around easily. Banks such as Alfalah, MCB and Standard Chartered Bank have online calculators that automatically compute monthly instalments based on different variables.
Although the process may seem cumbersome, an individual with a reliable income stream and proper documentation should be able to obtain a personal loan relatively easily. However, given the high rates of interest, it would appear many opt for the friends and family route whenever possible.
Fatima S. Attarwala heads Dawn’s Business & Finance desk. firstname.lastname@example.org