India needs guardrails around shadow loans

India's Reserve Bank of India (RBI) is contemplating new regulations around nonbank lending institutions, as some have been offering excessive and flexible loans to self-employed professionals and small business owners. These "shadow loans" could lead to the perpetuation of bad debt, a problem that is also present in the banking sector. However, given the vast number of nonbank financiers in India, surpassing 9,000, regulation is challenging.

The RBI is proposing that nonbanks should offer only term loans with predetermined repayment schedules, while overdraft limits should only be available through banks. This proposal aims to safeguard against the risk of evergreening bad debt, and is based on the observation that over 200 million self-employed workers lack a reliable source of financing to smooth their cash flows.

Currently, nonbanks offer flexible flexi loans with adjustable repayment schedules, allowing borrowers to withdraw and repay funds as needed. These loans have proven beneficial for borrowers who use around 70% of their accessible limit, reducing interest costs by between 200 and 250 basis points.

Nonetheless, concerns remain about the larger issue of employment precariousness in India. Only less than half of urban workers and 13% of rural workers receive a monthly salary. As AI continues to impact salaried jobs, the importance of self-employed workers accessing the formal financial system is increasingly apparent. The solution, therefore, must be to encourage competition in the financial sector rather than banning this particular product.