LENDER OF FIRST RESORT
Loan sharks are a feature of poor countries. However, their role is often critical in the day-today lives of poor people for emergency finance, small businesses’ working capital and borrowing for consumption. Consequences can be disconcerting for those failing to keep up with repayments. Neighbours will discover the fellow is a poor credit when a loan shark frequents the home loudly demanding payment. Loans sharks will even suggest that the customer sell a kidney to raise the cash, and perhaps offer to remove it for him.
For many people there is no alternative to this indignation. Banks and microfinance companies won’t loan moneyf or emergency doctors’ bills, school books or to replace the tuk-tuk’s snapped brake cable. Such requirements lead the poor – living from pay cheque to pay cheque – to frequent financial crises. Since they don’t have savings, loan sharks (moneylenders) charging annual interest rates from 40% to thousands of percent are their only option. Moneylenders are an ugly lot; without their ruthless collection practices, they would be out of business. Poor people are often self-employed or hold irregular jobs, rarely have proof of employment or regular cash inflow to a bank account. Banks don’t lend to them as it’s difficult to reliably verify that they have a regular income for loan repayment. Believing everyone deserves a chance isn’t reason to trust everybody or believe they are creditworthy.
Reeza Zarook and a business partner invested half a million dollars in Rukula – a business with an underlying belief in people’s honesty. It grants small loans to people without a credit history, whom Rukula’s employees have never met and without an asset as security. People are generally honest, goes a widespread belief. However, it appears irrational to build a business on that assumption. Rukula (meaning support) lends to people not considered creditworthy by the financial sector. Borrowers typically buy smartphones (82% of them), gas cookers and other household items from retailers registered with Rukula. Unlike in a hire purchase deal, the ownership of the product lies with the borrower. In leasing or hire purchase, the ownership transfers only after the final instalment is settled. Rukula signs a simple agreement with the customer, conducting all interactions though online messaging services.
Rukula can’t do much about customers intentionally overlooking to service instalments due weekly or monthly depending on loan conditions. Court action is an option but isn’t logical considering the Rs18,000 average loan amount.
During the four years since its founding, Rukula’s faith in its assumption of honesty was tes ted. “We were confident initially that good people will repay, but reality didn’t always reflect this. We’ve now changed that assumption to good people with financial discipline will repay,” concedes Reeza Zarook in an interview at Rukula’s sparsely furnished office along Colombo’s Fife Road.
“A significant amount of our time, during the early phase, was spent testing everything we knew. A key discovery was that people need a bit of a nudge to keep up with their loan instalments,” Zarook says about the 25,000 loans they have granted so far.
The results have informed the operation’s core back-office credit-checking system for new and returning loan applicants. Assessing a borrower’s ability to repay is at least as central to their business as providing the money. Typically, the process starts when a customer visits an electronics retailer like Abans or Softlogic to purchase an item (often a smartphone). Shopkeepers refer potential customers to Rukula for small loans. Rukula will not lend more than Rs36,000. A Rukula staffer evaluates, over the phone, potential customers’ credit in a brief interview, entering responses into the system. The shopkeeper takes photos on a phone of the potential borrower’s national ID, an electricity bill and a pay slip (if employed) for identity and residence verification. Nine out of ten such applicants are approved for credit. Credit is approved within ten minutes. Once the first instalment is settled though a mobile money platform, Rukula requests the shopkeeper to release the product.
A first-time borrower will pay 80% annual interest should she complete repayment in six months, the time frequently offered. So far 78% of loans have been repaid in 6 months, 88% within a year and 94% within two years. As Rukula doesn’t impose penalties, a slower repayment lowers a borrower’s annual interest cost. If a borrower takes a year to complete repayments on a six month loan, his interest cost falls by half. The financially disciplined are rewarded with lower rates on subsequent loans.
Rukula thrives because it operates outside the banking and finance company laws that impose strict provisioning requirements on overdue loans and prohibit high interest rates. Rukula risks only shareholder equity as it doesn’t accept deposits. However, to grow the business it has borrowed around Rs200 million from banks and has Rs400 million loans outstanding. Its loan portfolio is Rukula’s collateral for bank borrowing. Business growth is exponential without a corresponding overheads increase, except for interest costs. Twenty two employees oversee the portfolio and managed 300% growth in the year to April 2016 and 500% in the 2016/17 financial year.
Lenders need to be exempt from onerous rules and interest rate caps to profit from small loans.
“Today, our relationship with banks is one of coexistence and collaboration,” Zarook says. He points out that banks don’t give small loans because there is no money in it. “Banks have access to low-income markets through Rukula, which is a win-win for all,” he asserts. Regulations require banks to back with more capital riskier lending. A bank wouldn’t want the risks and administrative burden of a mass of overdue loans, common in moneylending or loan shark operations. Banks must provision for overdue loans and this reduces capital available for other business risks.
Zarook says the business benefits from both up and down economic cycles. People borrow more during a down cycle. However, they would generally pay faster during the up cycle, probably to take on another product during the next down cycle. “Even though our sales would hike during the down cycle, repayments take longer. On the other hand, recoveries are faster during the up cycle.” Rukula’s customers have the flexibility to repay whatever they can afford.
“We don’t believe in the concept of non-performing loans, as we believe that every loan is performing to some extent, even though it’s below contractual obligation. Keeping that in mind, we designed our model, expecting people to be late. We are okay with it as long as they keep repaying us even as little as 200 rupees,” says Zarook.
“The beauty of the model is that customers aren’t penalized for late payments. The only difference is, those taking longer than six months to repay won’t receive additional benefits especially in the form of lower service fees, lower rates and higher loan values,” Zarook points out.
Around 6% of loans have been defaulted, as borrowers decided to abscond and disappear forever.
“The lesson here is to finish. Once a customer finishes repaying, we help him buy another product again. There are a few customers who are on their fifth product,” says Zarook.
Rukula does not fit the description of a loan shark. Loan sharks will not inquire about the purpose for borrowing or check if the fellow can pay it back. They instead intimidate and threaten when repayment is delayed. In that respect Rukula is more bank-like, lending for a purpose and requiring proof of earning for repayment.
However, relying on banks for funding, and financial institutions’ alarm about too high an exposure of their loan book to unregulated lending, may constrain Rukula’s ambitions.
Rukula has 17,000 customers, some of whom have obtained more than one loan from the company. The company has also not raised any external equity barring the seed capital Zarook – who cashed out of e-commerce startup Anything.lk – and his business partner have invested.
The vagaries of a moneylending portfolio can be exacerbated during an economic down cycle and this risk concentration is a primary reason why moneylending businesses don’t rival banks. Banks will prefer to limit their consumer lending exposure to the least bankable segments.
In the US, Wonga, a purely online so-called ‘payday lender’ has scaled successfully in competition with others. However Wonga is selective about whom it lends to. Around 60% of loan applications are rejected by Wonga compared to Rukula’s 10%.
In January 2018, the Catalyst Fund Company – a global philanthropic grant fund providing capital and advisory services to fintechs – partnered with Rukula. As part of the agreement, Catalyst Fund will provide artificial intelligence and machine learning expertise to Rukula’s credit scoring process.
It’s expensive to be poor. For instance, a family without a fridge at home – to keep perishables and cooked food for longer – must visit shops frequently and cook more often. Owning a fridge will save many hours, which can be spent on something productive or at leisure. Because the poor can’t afford basic stuff – like a refrigerator or gas cooker that
boosts productivity – the cost of their meals is likely far higher than a household with a fridge and gas stove.
Inflation also hits the poor harder. Because they don’t own assets – the values of which usually rise in step with general price increases – they suffer more. Salaries rarely keep up with inflation. Rent, energy and food costs, which take up the bulk of their budgets, also rise faster with inflation compared to the costs of services, which the rich spend most of their income on.
Credit to the poor is effective when it helps them become more productive and those gains then help repay the loan. This is not a new idea. I M Singer & Company, founded in 1851, provided credit to tens of thousands of women to purchase sewing machines, allowing them to pay for the purchase in monthly instalments with money earned by sewing or savings from not having to pay tailoring costs in the household.
The existence of thriving money-lending businesses and loan sharks is evidence of two things. Firstly, many people are locked out of the traditional sources of credit either because their incomes are irregular or because their credit histories are poor. Secondly, they offer customers convenient injections of cash.
Loan sharks thrive because economic growth is weak. Moneylenders like Rukula are successful because the industry operates outside the laws applied to banks and finance companies. This is also a challenge for moneylenders that want to scale. Financial sector businesses scale due to their ability to access low-cost money through deposits. Rukula is unable to do that and must rely on borrowings from banks, which may become jittery about their high exposure to poor credits. To overcome the challenge, it can mine data to understand customers and trends to gain an edge and thus reduce risk. The other option is for the company to admit new investors.