Improving Regulation of Punitive Rates for Delinquent Loans
Reforming the calculation of lending rates could improve delinquent loan collection.
In the Republic of Korea, enforcement decrees of the Loan Company Act apply different regulations regarding interest rates on delinquent loans for banks and other lending institutions. To improve the scheme, we need to reassess the current system of calculating the lending rates. Specifically, it would be desirable to make borrowers who fall behind the repayment schedule to bear the burden of lenders' loan management cost, and the late fees may be charged corresponding to the number of delinquencies rather than the amount of the loan.
Currently in the Republic of Korea, enforcement decrees of the Loan Company Act apply different regulations regarding interest rates on delinquent loans for banks and non-banks. Banks' rates are regulated by the Bank of Korea, while non-banks' are regulated by the Financial Services Commission. For banks, when the interest rate on delinquent loan exceeds 25%, a punitive rate for delinquent loans is capped below 1.3 times of the agreed rate. For other lenders, for the same condition, the penalty rate is capped below 12%. Meanwhile, the Loan Company Act caps a statutory lending rate including the punitive rate for all lending institutions at 27.9%, and it is poised to be lowered to 24%.
The punitive rate rises higher for all lending institutions as the period of delinquency extends, but the range varies―6~8% for banks and 5~12% for savings banks and specialized credit companies. Also banks internally put a ceiling on the interest rates for delinquent loans at 15%.
That is, the level of lending rates and punitive rates for delinquent loans render the current regulation on the maximum rate ineffective. Banks' average lending rate stays below 10%, with the punitive rate for delinquent loans at 6~8%, and combined together, they fall well below the statutory maximum rate of 25%; moreover, nor are banks likely to impose such a staggering level of interest rates. For other lending institutions, the average rate for credit lending is 24.05% for savings banks and 17.05~28.29% for installment financing companies, leaving them little room to add punitive rates.
Meanwhile, in many other countries, borrowers bear the cost burden of delinquent loans in various ways, for instance, by paying late fees corresponding to the number of delinquencies. Application of either penalty rates or late fees can be seen as asking a premium for revealed credit risks, and can be justified not only for urging repayment but also in consideration of lenders' loan management costs, opportunity costs and recapitalization costs. According to the Republic of Korea's Civil Act, a borrower should compensate for a default (either by intention or negligence). Without a punitive rate, the risk of moral hazard would escalate and the problem of adverse selection would arise.
Still, to improve the interest rate scheme for delinquent loans, we need to assess the current system of setting the lending rates. At the time of approving a loan, a borrower's credit risks are taken into account, but it is hard to tell in advance who would actually make repayment in time and who would fall behind the schedule. For this reason, some of the interests may be waived for borrowers who repay in time, and additional cost burden imposed on delinquent loans, to ensure equality and efficiency.
Thus it is important that delinquent borrowers bear the cost burden of managing delinquent loans, and in this regard, the idea of applying late fees for delinquent borrowers may be considered. The amount of late fees may correspond to the number of delinquencies rather than the size of the loan, given that the management cost is mostly a fixed cost and little affected by the loan size.
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The views expressed in these articles are those of the authors and do not necessarily reflect the views of the Asian Development Bank, its management, its Board of Directors, or its members.