Five Star goes after customers who are usually single-shop owners like kiranas or barbers or self-employed, like plumbers and electricians. Rangarajan says, even though the ticket size of Rs 3-4 lakhs seems small, that’s the size of loan their customer needs. They recover the loan over a 5 to 7-year period. Longer tenures typically help companies build a larger balance sheet, making operations more efficient, says Investec’s Jain.
However, servicing this segment is tricky. “The combination of small ticket size, long tenure, and collateral is a tricky one,” says Jain. He says that NBFCs in this space will need to assess borrowers rigorously, with the rejection rate going as high as 60-70%. Also, he says, it is operationally intensive as the bounce rate (people who skip repayments) is as high 20-30%. There’s also the matter of longer tenure loans being more risky, as businesses are likely to experience more ups and downs over a longer period of time.
Yet this is what Five Star has gone after.
The collateral safety net
Fintech lenders have disbursed close to Rs 10,000 crore in the last seven years, according to the estimates of industry insiders. But ask Lakshmipathy D, Five Star’s chairman and MD, about the trend of unsecured lending, and he shoots it down. Unsecured lending is anathema to the 45-year-old, and he just stops short of calling it what he really wants to—lazy. Opting for diplomacy, he says it is “less work to do.”
However, while it is less burdensome, it has a sizeable risk. China is a cautionary tale of what happens when borrowers have access to easy money. Chinese households now face a $7 trillion debt, 22% of which were loans given to small businesses. While India is no China, China—in its own extreme way—showed that easy deployment of money and algorithms that assess repayment do not a lending business make.
Five Star knows this too. Which is why it insists on collateral. This collateral is used more as psychological leverage though if Rangarajan is to be believed. “In all these years we have not repossessed a single property,” he says. But they could if it came to that. Once a property has been mortgaged, borrowers have no choice but to pay to repossess the documents of their property.
The importance of collateral is something that Five Star learnt over the course of its first 20 years of existence. “There is no difference in repayment rates between secured and unsecured lending when the times are good. But there is a stark difference in bad times,” says Rangarajan sagely.
Moreover, when a borrower defaults on an unsecured loan, the behaviour sticks and it’s difficult to get the defaulter back on track, adds Rangarajan. Which is why even today at Five Star, when a borrower has repaid his money in full and the company has his repayment history, it still demands collateral when comes to a subsequent loan.
This safety net means that Five Star is comfortable lending at interest rates of up to 25%, not far removed from what fintechs like Lendingkart and Capital Float charge. Rangarajan says that for the type of risk fintechs take, they should be charging higher interest rates. However, despite the added risk, fintechs keep interest rates in check so they don’t become too costly compared to other NBFCs. Moreover, the Reserve Bank of India—India’s banking regulator—does not like businesses charging higher interest rates, unlike in China, where there is no set cap.
While the collateral-based approach takes the risk of recovery to its lowest degree, executing this is nothing short of herculean.
Five Star though has decades of experience in this space to count on. Even when it first started, originally to finance the purchases of two-wheelers and three-wheelers, they lent mostly to borrowers who were self-employed and ran small businesses. Despite the business changing in the intervening years, the profile of Five Star’s customer has remained constant, meaning they know their customer very well.
It is this knowledge that led them to hinge their business on collateral in the first place. Five Star prefers to lend to those who can mortgage their self-occupied property since property is a primary need for the segment they serve. “Three to four years into a business, they [Five Star’s customer base] all aspire to buy property because that is their go-to source of investment,” says Rangarajan. So, of the 50 million businesses at least one third will have collateral, he estimates.