Personal loans by non-banking finance companies (NBFCs) are mostly extended as revolving lines of credit, through the use of online apps. The lender would be happy if there were no regulatory obstacles to provide this line of credit by way of a credit card, or even a virtual credit card.
But there are regulatory barriers to NBFCs issuing credit cards. Therefore, NBFCs end up giving revolving lines of credit. However, the issue is, whether or not a revolving line of credit is an alternative to a card or a virtual card, and if yes, then are there regulatory issues in NBFCs giving personal revolving lines of credit?
The master directions from Reserve Bank of India (RB) recognise extending a line of credit by expressly providing for a prudential framework for a special mention account (SMA) classification for a revolving line of credit.
The issue is not whether the credit is personal, or for business purposes, such as a working capital line of credit. There is a general notion that NBFCs cannot extend working capital lines of credit, while they may give working capital loans. It is important to examine this issue at length.
Revolving Line of Credit Explained
A revolving line of credit is a mode of lending wherein the lender agrees to lend an amount equal to or less than a pre-determined credit limit, as approved for the borrower. The parameters for fixing the limit may be the credit appraisal of the borrower, or, as in case of working capital, the asset liability gap.
The borrower may continue to use the line of credit - he may keep repaying, in which case the drawn amount comes down, and then he may re-draw, when the drawn amount goes up.
The credit limit gets restored on repayment being made by the borrower. Such a line of credit may be secured or unsecured, depending on the agreement between the lender and the borrower.
The line of credit is essentially governed by the agreement between the parties. The term “revolving” does not imply that the line of credit is not subject to a review, or repayment. Each line of credit has a review period.
If the lender decides not to revolve the line of credit, then the line of credit becomes a term loan, and has to be paid down as per the terms of agreement between the lender and the borrower.
For certain types of facilities, a revolving line of credit is aptly suitable. While in the case of businesses, working capital is best financed by a line of credit, in the case of personal finance also, the ability to draw on the basis of a line of credit extends the finances of the borrower, and allows him the flexibility to tap into the funds when needed, and pay it off when not needed. There is, of course, a standing commitment on the part of the lender to provide the facility amount of the limit, for which lenders may charge a continuing commitment charge.
A line of credit implies a commitment to disburse. To the extent of the amount already disbursed, there is a funded facility. To the extent of the limit sanctioned but not yet availed, there is an unfunded commitment to disburse. Undisbursed or partly disbursed loans are common in case of term loans as well – for example, a home loan may take a long time to get disbursed.
Similarities Between A Credit Card And Revolving Line Of Credit
A credit card is a payment card, which the borrower may use for making payments at the point of sale (PoS). The lender makes payment on behalf of the borrower and then recovers the same from the borrower. A detailed explanation of features of credit cards maybe referred to in one of
our write-ups.
A revolving line of credit shares some of its features with a credit card, due to which they are seen as equivalents. The similarities between both the modes are as follows:
- Borrowers can take the disbursement as and when needed.
- The lender, in both cases, always reserves the right to reduce the credit limit.
- The lender has to maintain optimum amount of working capital to meet the disbursement demands of the borrowers.
- The credit limit is restored on repayment being made.
Disparity Between Credit Card And Revolving Line Of Credit
Based on the usual practice of the market, the following are the key points:
- Security: A revolving line of credit may be secured or unsecured, whereas, a credit card is always unsecured.
- End-use restrictions: There are no restrictions on end use of funds in case of a credit card. However, in a line of credit, the end use is restricted by the purpose mentioned in the loan agreement for availing the loan. Of course, the purpose may be generic – for example, personal use or general business use.
- Restriction w.r.t. withdrawal of fund: A revolving line of credit does not require a purchase to be made in order to get the funds disbursed. It allows money to be transferred into bank account for any reason without requiring an actual transaction, whereas, in the case of a credit card, payments can be made at PoS only and thus, it requires an actual transaction for the disbursement to be made.
- Interest Period: In the case of a credit card, if repayment is made within a specified term, no interest is usually charged. However, after the specified period, a high rate of interest is charged. On the other hand, in the case of a revolving line of credit, the interest is calculated from the day of disbursement being made at a comparatively lower rate.
- Credit Limit: As a market practice, a revolving line of credit maybe availed for business purposes or personal purposes and thus, has higher credit limits as compared to a credit card which is generally used for personal purposes only.
- Manner of Repayment: In case of credit card, funds once availed have to be repaid within a specified period of time, in lump sum. On the other hand, when credit is availed from a revolving line of credit, the same is repaid by the borrower in instalments.
- Risks: Credit cards come with the risk of theft, misuse etc. However, the same maybe done away with, in case of virtual credit cards.
The Fundamental Difference
The abovementioned differences are, in essence, superficial. They are based on practices of the market, which may easily be reshaped suiting the needs of the parties. What is the key difference between a card, a virtual card and a revolving line of credit? €‹
A logical difference that one finds is that while in the case of a credit card, the borrower uses it to make payments to third parties, in case of a revolving line of credit, the disbursements are made to the account of the borrower from where the borrower may use it for the required purpose. A credit card is an instrument: it can be used to settle payments, and therefore, becomes a part of the payment and settlement system. A straight line of credit may be tapped by the borrower. After tapping the line, the borrower may use it for making payments and settlements. But the line of credit itself is not an instrument of settling payments.
Therefore, fundamentally, while a revolving line of credit is a promise by lender to the borrower, a credit card is a promise by the lender to the world at large. A lender in case of a line of credit is obliged to make disbursement to the borrower, and only the borrower has a recourse against the lender. However, in case of issue of credit cards, the issuer or the lender is obliged to make payments to any authorized merchant who supplies goods and services against the card.
The Burning Question- Can NBFCs Extend Revolving Line of Credit?
Logical Answer: The distinction between a revolving line of credit and credit card has already been highlighted above. Further, it is also quite evident from the above discussion that a credit card has wider risks than has a revolving line of credit.
In case of a revolving line of credit, the failure on the part of the lender to disburse the sanctioned amount impacts the borrower. However, if a card issuer defaults, it may affect all those merchants who might have used the card to supply goods and services. There may be a contagion impact, and therefore, the failure of a card issuer has systemic implications. Thus, capital adequacy, solvency and liquidity are far greater issues for a card issuer, than in the case of a plain lender against a revolving line of credit.
The above discussion leads one to conclude that there are no specific concerns in case of granting of a revolving line of credit. The only concern may be the exposure on account of the sanctioned but undisbursed amount, for which off-balance sheet credit conversion factors exist.
Regulatory Support: The above logic may further be supported by the provisions of the
Prudential Framework for Resolution of Stressed Assets, where the RBI has recognized the practice of extending revolving lines of credit by NBFCs. Following is the relevant extract from the said framework which is applicable to scheduled commercial banks (excluding regional rural banks- RRBs), pan-India term financial institutions, small finance banks, deposit taking NBFCs and systemically important NBFCs (NBFC-SI).
In the case of revolving credit facilities like cash credit, the SMA sub-categories will be as follows:
So, firstly there are no express restrictions on extending revolving line of credit and secondly, the RBI recognises such credit in its frameworks. Therefore, it is safe to take this recognition as a provenance to allowability of extending revolving lines of credit by NBFCs.
Further, the provisions relating to the restructuring of accounts of borrowers by NBFCs as per the Master Directions also recognize extension of revolving cash credit. The provisions, however, recognises that roll-over of short-term loans based on actual requirement of borrower and not as a concession considering the credit weakness of the borrower, shall not be considered as restructuring of accounts. For-this purpose, short-term loans shall not include properly assessed regular working capital loans like revolving cash credit or working capital demand loans. The relevant extract is as follows:
“In the cases of a roll-over of short-term loans, where proper pre-sanction assessment has been made, and the roll-over is allowed based on the actual requirement of the borrower and no concession has been provided due to credit weakness of the borrower, then these shall not be considered as restructured accounts.
Further, short term loans for the purpose of this provision do not include properly assessed regular working capital loans like revolving cash credit or working capital demand loans.”
Concerns on Maintenance of Capital
In case of line of credit, the disbursements are to be made as and when the borrower requires, therefore, the NBFC should maintain adequate capital and liquidity to meet such abrupt demands. The RBI Master Directions take care of the solvency concerns of the NBFCs extending revolving line of credit. Liquidity standards, internally set by the NBFC under the ALM process, also contain safeguards by taking the undisbursed amount of committed facilities as “required funding”.
The
Master Directions for NBFC-SI requires the NBFC-SIs to maintain a capital to risk assets ratio (CRAR) of 15%. It provides the detailed methodology of how the risk-weighting of assets is to be done to meet the CRAR requirement.
Following is the extract from the said methodology:
Thus, depending on the terms of the revolving line of credit, a credit conversion factor will be multiplied to the total amount of obligation and the capital will be maintained accordingly.
“outside liabilities” means total liabilities as appearing on the liabilities side of the balance sheet excluding 'paid up capital' and 'reserves and surplus', instruments compulsorily convertible into equity shares within a period not exceeding 10 years from the date of issue but including all forms of debt and obligations having the characteristics of debt, whether created by the issue of hybrid instruments or otherwise, and value of guarantees issued, whether appearing on the balance sheet or not.”
Due to the leverage restriction, NBFC- non-systemically important (NSIs) shall also automatically be restricted from lending more than their capacity.
Nuts and Bolts to the Structure of Revolving Line of Credit
From the above discussion, it is clear that NBFCs may extend the revolving line of credit. However, from the prudence perspective, following are certain essentials that must be kept in mind by the NBFCs while extending a revolving line of credit:
- It is advisable for the lender to retain the right to unconditionally cancel the commitment of the revolving line of credit. In such a case, the credit conversion factor for such exposure shall be “0”.
- The terms of the line of credit must provide for review and reset as the lender may deem fit.
- The lender must ensure that it maintains liquidity to meet abrupt calls for disbursement by the borrower.
- In case the tenure of the revolving line of credit is pre-determined, the credit conversion factor shall accordingly be taken as 20 or 50.
(Kanakprabha Jethani is an Executive at Vinod Kothari Consultants P Ltd)
