The problem with Secured Credit Cards
Secured credit cards are interesting offerings that have cropped up in large numbers recently. These cards are targeted at people who either don’t have much of a presence in the credit bureaus or have defaulted previously. The proposition to the user is that they can build their credit profile and enhance their credit score which can eventually qualify them for unsecured credit.
A secured credit card is typically issued against a Fixed Deposit that acts as collateral. In case the customer defaults, the Fixed Deposit is liquidated. Secured cards may also be issued against gold or lien marked Mutual Funds, although the latter is rarely seen in India.
A secured credit card is preferred under the following circumstances:
- The user doesn’t have a credit history or has a very thin credit provide, and their income profile cannot be ascertained
- The user has defaulted in the past
- The issuer is not confident about the data that is available to them or voluntarily shared by the customer
Some of the cards that you will find in the Indian market:
- Kotak Dream Different
- Bank of Baroda Assure
- Paisabazaar Step Up card (SBM Bank)
- OneCard (SBM Bank)
Secured cards are a global phenomenon. Even in a mature market like the US which has >650 million credit cards, there are secured cards.
Does it serve the purpose of democratising credit?
On the surface, secured credit cards seem like a fantastic proposition for everyone involved.
The customer: The customer isn’t denied a card, achieves the goal of improving the credit score, and also gets decent returns on their FD.
The issuer: Issuers face zero risk as they can execute the lien against this FD if the customer defaults on the card.
The regulator: The regulator gets to improve overall credit inclusion metrics.
So, it’s a win-win for all the parties involved!
But does it actually serve the purpose of ‘credit’?
When we look carefully, we will find that the repayment data from a secured credit card is not very useful in assessing the creditworthiness of a customer. This is due to (a) the lender may not have done any detailed assessment of the borrower and (b) the lender did not give the customer a choice in the matter of repayment.
Let’s dig a little deeper into the matter.
CREDIT — An exchange of trust
Every time a person borrows, they are putting their trustworthiness on the line. When they repay in full and on time, then they have earned the trust of the lender. In a secured card setting, however, there is very little trust in the entire equation. Both the lenders and borrowers are fearful of each other. The lender is scared because they don’t know if the borrower is credit-worthy (ability to repay) and trust-worthy (intent to repay) enough to lend to. They mostly do very little research on the customer beyond the identity of the customer. The collateral from the customer in the form of cash (FD or mutual fund or gold) essentially becomes a proxy to judge intent and ability to repay. The borrower is scared because they won’t be able to recover their asset/collateral if they don’t repay in full and on time.
This difference in the setting influences the behaviour on both the sides significantly. The repayment data of a secured loan is highly biased and offers very little concrete insight into customer behaviour. The data would be very useful when the customers are given full freedom. It would help collect natural and independent consumer behavioural patterns thus contributing to a healthier credit system.
One may argue that the current system also uses fear through the threat of loss of credit score to enforce repayment. This argument doesn’t cut much ice since it is a common denominator across the entire credit system. This cannot be equated to the threat of actual loss of value (cash or gold) and the loss of credit score as well.
A systemic problem?
Issuing secured cards in large numbers can potentially lead to a systemic problem if the data is not labeled correctly and discounted adequately. This cohort of customers whom the system does not understand fully but onboarded via a secured credit card facility will eventually be issued credit in an unsecured fashion by unsuspecting lenders. And, I can say with reasonable certainty that the performance of this cohort will be different from the rest and it will certainly be poorer. This could eventually translate to higher NPAs and have further adverse effects.
Obviously, I hope that secured credit cards wouldn’t end up causing a systemic problem and that I will be proven wrong here. I will be the happiest if secured credit cards program serves the broader societal requirement of credit inclusion.
Alternatives to secured credit to solve cold start?
If we take a step back and observe this problem for what it is, we will see that it is a cold start problem. There isn’t any doubt in my mind that we should price the risk higher for those with no/bad credit history. Perhaps, there are other ways to address this problem without meddling with the core equation in the lender borrower relationship.