An insecure victory


While lending is central to a bank’s business it need not necessarily lend to make a profit. That is why failure to balance the interests of bankers and their customers – which at first may look like a triumph of justice and a shield against greedy and merciless Shylocks - can produce calamity. And that is why the recent ruling of the Supreme Court, though a serious blow for lenders, is also a dubious victory for borrowers: from now on a loan will be even harder to come by.

Since February 2008 the Russian Development Bank has been fighting with the Federal Service for the Oversight of Consumer Protection and Welfare, Russia’s consumer rights watchdog, over the right of lenders to increase interest rates, impose default penalties, and insist on dispute resolution in a court where the bank is located.

The lower courts had ruled in favour of the bank. Yet on March 2 the Presidium of the Supreme Arbitrazhniy Court, contrary to most expectations, found for the customers.

Though the court’s decision hangs on a string of legalistic justifications the underlying question is simple: in these troubled times who should the law favour, banks or customers? Russians say that it definitely should be the latter.

Three months earlier, in November 2009, the Supreme Court in Britain faced a similar question and its answer, apologetic and tentative, was in favour of the lenders.

The question was whether the Office of Fair Trading (OFT) could assess the fairness of overdraft charges set out by lenders, which the OFT claimed were neither clear nor subject to effective customer control. Had the court ruled against the banks, which included HSBC, Royal Bank of Scotland, Lloyds Banking Group, Barclays and other financial giants, they were to lose around $4.3 billion a year, a third of their annual profit, and claims dating back many years might also have been presented.

In these troubled times who should the law favour, banks or customers? Russians say that it definitely should be the latter.

The case though decided on a fine point of law - namely the EU Directive on Unfair Trading in Consumer Contracts - had such an impact that the judges launched into a flood of explanations. ‘The general public (who are understandably taking a close interest in the matter) are not well aware of its [the case’s] limited scope,’ Lord Walker had to say. The question was not, the judges went on, whether the bank charges were fair, but whether the OFT could launch an investigation into whether they were fair.

Free of British circumlocution Russia’s Supreme Court delved into the matter and ruled that it is illegal to include in the terms of the loan agreement the right of a bank to increase the interest rate in the event of a change in the customer’s circumstances such as, for instance, loss of job or illness or even as a reaction to an adverse move on the financial markets. Also, a penalty for the failure to make a payment on time is now unacceptable even if it is a part of the contract, and a bank and a customer cannot agree to have their disputes resolved in a court at the location of the bank, not of the customer.

Russia is unusual in that much of its lending to individuals is at a fixed, rather than a variable, rate. Yet that fixed rate is of a very special nature, so it is not fixed at all.

Banks stipulate in their loan agreements that they are entitled to change, and do so unilaterally, the interest rate in the event of the worsening of the borrower’s financial position, redundancy or even the increase by the Central Bank of its exchange rate. If a customer disagrees with new terms a bank would cancel its outstanding obligations and accelerate repayment: the whole debt and interest would become immediately due.

Thus, what looks like a fixed term loan becomes, essentially, an overdraft of the worst possible kind: a lender may not only increase the rate but terminate the facility for reasons outside the borrower’s control and this without default in payment.

And herein lies the rub: if a bank decided to invoke the clause the situation is probably lost. Apart from obvious practical obstacles in enforcing and collecting the debt it would most likely trigger demands from other lenders and as a result the borrower would be unable to satisfy any of them. The clause, therefore, contains a scenario, damaging not only to an unfortunate customer but to a bank itself.

The court’s decision to stop this practice, then, is understandable and fair. What is striking is its objections to penalties for the failure to make a payment on time: most legal systems, and that is reinstated on the international level by the UNIDROIT Principles, do not mind such a penalty unless the amount is outrageously high.

Yet the recent ruling hinges not on the general principles of the law on obligations - at the end of the day parties entered into the contract voluntarily and their will should be respected - but on the rights of the consumer. Ironically, this protection will not, most likely, extend to a clause which would provide a reduction of interest on punctual payments: a clear demonstration of how in law a mere change of wording can affect reality. What a bank needs to do is merely reword the agreements.

Though technically correct the position of the court regarding a forum for resolution of disputes does not take into consideration the reality. Russia is a big country and the requirement for a bank to file a case in a court where its customer lives, or just moved, is an unnecessary complication of the enforcement process, the step a bank should be discouraged to make, yet when it does follow this route it should be reasonably fast and straightforward.

This decision looks good long-term. Short-term it is more of a hurdle than a cure: retail banking in Russia is increasingly concentrated and the ruling is a help to leaders and a hindrance to outsiders. Also, there is a risk that this has been a too big favour to consumers: that done, the authorities might be tempted to delay the introduction of the law on individual bankruptcy even further. A stroke of luck may turn out just an excuse for not doing what is really needed.


March 5, 2010
text: J. Vermin
picture: NatalyArt -



Bank customers strike back