What If Your Lender Fails?

Recently, RBI imposed a moratorium on withdrawals from a leading private bank. The depositors and the investors with the bank were understandably worried. The stock price tanked the following morning. We have been focusing on how the various depositors will be affected. As I understand from the bank’s restructuring plan, the depositors are completely safe and won’t have to take any hit. The equity investors won’t be as lucky.

What if you have borrowed from this bank? Can you face a problem? Depends. If the lender has disbursed the complete loan completely, then there is no problem. The lender/financial institution will be merged with another entity or restructured. Your liability will continue as it is. You must keep paying EMI. No change.

On the other hand, if your loan has not been disbursed completely, then we can have a big problem. This can happen in construction linked loans. Under such loans, the payments to the builder are linked to achievement of construction milestones. As the milestones are reached, the developer requests you for payment. You forward the request to the bank and the bank disburses the amount. Now, imagine a scenario. Your builder asks for the next installment, but your lender can’t disburse the funds. What will you do? Non-payment of the instalment to the builder will usually result in heavy penal interest as the terms of the sale agreement.

In this specific case, the moratorium was temporary. I hope the disbursements have resumed once the moratorium was lifted.

Perhaps, I am too optimistic. Lifting of moratorium on withdrawals does not mean that the bank can start lending or will have money to lend. We have examples from the recent past where the resolution has not been so swift. A co-operative bank is not operational for almost six months or a housing finance company which is yet to come back on track 18 months after the problems first surfaced.

This is an interesting aspect. When it comes to credit/loans, we usually focus on the risk of the borrower not paying back. However, there is a risk that the borrower also faces. What if the lender fails and can’t meet its commitments?

What Will You Do in Such a Case?

I don’t think there are too many options. If the problem is temporary, you can access your emergency funds or ask friends/family for a short term and pay to the builder. However, if the problem is drawn out and the crisis is not resolved, you have a serious problem at hand. The builder will keep asking for instalments as construction milestones are met. How will you make the payments? You might have to liquidate your other assets to make these payments.

You can go to another lender and ask for a loan. However, I am not sure how comfortable your new lender will be in offering you the loan. Your existing lender has the first charge on the property. The new lender will have a second charge on the property. The new lender may ask for additional security or comfort before it offers you the loan. A lot may depend on your credit and professional profile too.

Is There a Way to Plan for This Kind of Emergency?

You can’t possibly plan for these events. Such events are not frequent. An emergency fund will help. However, we usually keep a few months of expenses in an emergency fund. However, the payments to the builder can be very high. Your emergency fund can fall short in such cases.

Secondly, if you have a construction linked home loan and you find that your lender is struggling, you can reassess your position. Consider the quantum of expected payments and your ability to generate liquidity. If you believe you would struggle if the lender stopped disbursements, you can try to refinance your home loan with another bank or housing finance company. To an extent, it is an irresponsible comment, but we must also be pragmatic.

These are not everyday events. The last time, a proper bank (Global Trust Bank) failed was in 2004. Later, it was merged with Oriental Bank of Commerce. The depositors were saved that time too. And equity investors got crushed there too. I don’t know how long it took before loan disbursements resumed. Remember, the scheduled banks will be resolved fast. The resolution of Housing Finance companies or co-operative banks may take an eternity, especially if those are small ones. We must also note the Government can’t come in and rescue financial institutions all the time. This will lead to moral hazard. If financial institutions had such assurance, they might indulge in even riskier loans and such events will become frequent. So, you can expect some of the lenders to fail. You will keep waiting for Government intervention and it will never come. Then, there are lenders that are too big to fail. Such lenders will meet swift Government and regulatory action.

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