Demand and call loans: Economics and regulatory considerations

Vinod Kothari | finserv@vinodkothari.com

From lenders’ perspective, demand and call loans seem to be as liquid as money in a bank fixed deposit, and yet an option to earn substantially higher interest rates. The practice of demand loans exists in the financial marketplace; at the same time, it is often commonplace in the case of intra-group loans. However, there are various risks, considerations and regulatory implications in case of such lending.

This article goes beyond Reg. 28 of the Scale Based Regulations of the RBI and discusses economics, policy issues, liquidity and credit risk considerations, both for the lender and the borrower, as well as issues like NPA treatment, expected credit losses, etc.

What is a demand/call loan?

The word “call money” is typically used in the banking sector for very short-term loans, which are callable at any time by the lender. Demand loan is a term usually associated with longer-term loans, though with no fixed repayment date, that is to say, the loan may be demanded back by the lender at any time. The following features of demand/call loans are discernible:

• There is no fixed repayment date, but that does not mean there is no outer date for seeking repayment of the loan at all. For example, the terms of the loan may say – the lender may seek repayment of the loan at any time; however, if any earlier repayment is not demanded by the lender, the loan will be repaid on its 1st anniversary. Hence, there is an outer date, subject to the possibility of the lender demanding repayment at any time.
• Given its nature, the loan is also puttable by the borrower, that is, repayable by the borrower at the borrower’s instance. It does not seem logical to impose a prepayment penalty for earlier voluntary repayment by the borrower.
• Does the demand loan have to be repaid immediately upon demand? Except in the case of call loans which are very short-term loans by nature, a demand loan may provide a certain number of days after demand, for example, 14 days after demand is made by the lender.
• Can the repayment of the loan be demanded by the lender partially? The answer seems to be affirmative; of course, the borrower may repay the whole of the loan.
• The principal amount of the loan is payable on demand; how about the interest? The interest should still be serviced regularly. Reg 28.2 (iv) and (v) expect interest to be serviced monthly or quarterly, unless the sanctioning authority records a reason for not insisting on regular interest service.
• In demand loans, liquidity evaluation is as equally as important as the credit evaluation of the borrower. This is quite obvious, because however strong the financial position of the borrower, if the borrower does not have access to ready sources of liquidity, he will not be able to pay on demand.

Economics of demand loans:

A lender may be deploying surplus liquidity, which is to stay for an unspecified period of time, by giving demand loans. The option is much better than deploying the money for a series of short-tenure loans, as there may be reinvestment gaps in between. For example, if a lender estimates that there is liquidity to the tune of Rs 10 crores which may be needed at short notice but may remain unutilised for the next 90 days, it will be better to deploy the same in the form of a demand loan, than to give a loan for a month, and hope to reinvest the same each month-end.

For the borrower, a demand loan is essentially a device to reduce the cost of working capital. Assume a borrower who has a working capital facility with a bank for Rs 100 crores at 10%, and may avail a demand loan at 7%, the borrower benefits by reducing his cost of borrowing by resorting to a demand loan. When the repayment is demanded by the lender, the borrower may dip into the working capital facility and pay off the loan. 

However, demand loans have to be used by either party extremely judiciously. As for the lender, a contractual stipulation that the loan may be demanded at any time by the lender has no meaning unless the lender is sure of the liquidity position of the borrower. if the borrower does not have ready sources of liquidity, or does not have a collateral which is liquid and unencumbered, the lender may be putting himself into a liquidity risk relying on the ability of the borrower to pay off the loan when demanded. It is important to note that liquidity risk has a tendency to spread very quickly.

As for the borrower, likewise, demand loans create an asset-liability mismatch risk. The borrower should either have alternative sources of borrowing which are confirmed and readily available, or must have assets which may be disposed of without pain or losses.

While assessing the liquidity risk of the lender, can the cash inflows from demand loans be taken in a short-term bucket – say 0-15 days? Unless the lender can demonstrate that the contractual right of the lender to demand repayment is backed by liquidity arrangements at the borrower’s end, it may be wrong to treat these cashflows as short-term inflow.

Regulatory stipulations for demand loans:

The regulation above imposes several requirements in case of demand loans:

1. A practice of giving demand loans has to be backed by an appropriate policy. It is purely intuitive to understand that giving out demand loans cannot be a course of business for a lender. Between giving usance or term loans vs demand loans, it is quite natural that the latter fetches a lower rate of interest. Therefore, demand loans are pursued only for utilising intervening liquidity availability. Also, the rate of interest expected to be fetched by demand lending has to be higher than the cost of working capital credit enjoyed by the lender; otherwise, the lender will be better off paying off temporary liquidity to the working capital lenders.
2. The regulation expects the lender to fix a cut-off date for demanding repayment. It is tough to explain a so-called demand loan that stays undemanded year after year. Though the regulation permits the board-approved policy to accommodate a longer cut- off date too, but it is important to note that there need to be strong reasons for not demanding a loan back even after one year of grant. Therefore, the policy should then give the rationale for not demanding the loan back, and how does the lender’s board regard the loan as a good loan with no track record of principal repayment..
3. As mentioned above, interest should generally still be serviced regularly. Bullet repaying loans or loans which pay interest only on maturity are also permissible, but this also should be exceptional. Assessing the health of a loan will be impossible if there is no servicing of either interest or principal for a prolonged period.
4. The regulation calls for periodic review of performance of the loan. How would the performance of the loan be reviewed? Reviewing the performance is not limited to interest servicing. A prudent lender should also be reviewing the liquidity position of the borrower, including matters like –  is the borrower exposed to illiquid assets; is the collateral with which the demand loan was to be repaid still free and liquid; is the borrower demonstrating any significant increase in credit risk; etc. 
5. Such review must be done at regular intervals, but as per regulation, not later than 6 months after the sanction of the loan.

Renewal of a demand loan

The regulation clearly permits the renewal of a demand loan, after satisfactory performance during the review period. Once again, review cannot be limited to the track of servicing of interest. In fact, renewal is equivalent to a grant of a fresh loan. Therefore, the entire credit and liquidity evaluation as was relevant at the time of grant of the loan should be carried at the time of renewal.

Important point – does renewal means repayment of the existing demand loan, and then grant of a fresh loan by exchange of cashflows? Renewal generally means roll-over, without insisting on cash exchange. However, if an exchange of cashflows happens, then much of the concerns on the liquidity of the borrower will automatically get addressed.

NPA treatment of a demand loan

Reg 14.3 (iii) deals with the NPA treatment of a demand/call loan. It says, such a loan will be treated as having become an NPA if the loan “remained overdue for a period of more than [90] days from the date of demand or call or on which interest amount remained overdue for a period of more than [90] days.” 

As mentioned above, there has to be an outer limit to the loan, even if not demanded before. Therefore, the overdue period will start running from the date of the actual demand, or the cut-off date, whichever is earlier. If there is a renewal before the cut-off, of course, the date will be postponed to the next date.

ECL treatment in case of demand loans

There are two issues that will be confronted while computing ECL for demand loans – first, as ECL is the present value of the expected loss, how do we time the loss? Second, how do we capture any Significant Increase in Credit Risk (SICR)?

On the first question, the lender may assess the expected losses assuming the longest of the demand date, that is, the so-called cut-off date, assuming that cut-off date is within 12 months. This is on the basis that the probability of default is a time-curve, and is higher for a longer period of time than a shorter period. Therefore, the estimate of probability of default is more conservative if it is taken for a later date with the 12 month assessment period.

As for deciding whether the demand loan has moved from Stage 1 to Stage 2, the determination of SICR should be based on the range of factors mentioned in Para B 5.5.17 of IndAS 109.  These factors include (illustrative list of the factors): 

1. Changes in internal price indicators of credit risk;
2. Changes in the rates ans terms of existing financial instruments, like covenants or collateral requirements;
3. Changes in external market indicators of credit risk, including credit spread and credit default swap prices;
4. Changes in the financial instrument’s external credit rating;
5. Internal credit rating downgrades or changes in behavioural scoring;
6. Adverse changes in the business, financial or economic conditions affecting the borrower’s ability to meet its debt obligations;
7. Changes in the borrower’s operating result, asset quality, or organizational structure; 
8. Increase in credit risk on other financial instruments of the same borrower
9. Changes in collateral value or quality of guarantees affecting the borrower’s incentive to make payments;
10. Changes in the quality of guarantees provided by shareholders;
11. Expected changes in loan documentation or borrower behaviour;
12. Changes in the entity’s credit management approach based on emerging credit risk indicators.

 If there is a default in payment of interest, then the presumptive 30 DPD factor will apply additionally.