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RBI issues a ‘get out of debt (relatively) free’ card

A new circular from the Reserve Bank of India allows willful defaulters and fraudsters to make compromise settlements with banks.

In a turnaround from its 2019 guidelines, which dealt harshly with willful defaulters and fraudsters, in June 2023, the Reserve Bank of India published a series of circulars which make these borrowers eligible for compromise settlements.

Now, those who have purposely misused the funds lent to them or refuse to repay loans despite having the capacity to do so are also allowed to negotiate and reach compromise settlements with banks.

The rationale offered for this move is to cut red tape in the economy and make financial frameworks more borrower-friendly, but it has drawn the ire of bank unions and the broader public.

This is understandable for two reasons.

Firstly, it seems fundamentally unfair to treat individuals and companies who have squandered or embezzled funds just as one would treat a borrower in a truly distressed situation.

Secondly, the implications of this change for financial stability, especially in climate of high inflation and rising interest rates, could be significant.

Before this change, if the borrower had used the funds given to them illegally (fraud) or refused to pay even though he/she had the capacity to do so (willful default), then the bank and the borrower had to approach the Debt Recovery Tribunal.

The objective of the tribunal, as its innovative name suggests, is to extract as much money from the borrower as possible. This procedure is generally long and excruciating. It is so infamous that it actually acts as a disincentive for people to commit willful default or fraud, as they would remain embroiled in litigation for years on end.

A compromise settlement initially seems like a welcome alternative to this bureaucratic wrangling of funds.

Here, the borrower pays a certain amount of cash instantly. However, this has a flip side. A large proportion of the loan (around 70-80%) is ‘technically’ written off. This means that while the amount that is written off remains ‘outstanding’ on the borrower’s account and they do have a legal obligation to pay it, the bank recognises that its recovery is unlikely and agrees to not coerce the borrower into paying it (which is what Debt Recovery Tribunals would tend to do).

The red flag of ‘moral hazard’ is glaringly visible here. If you know that you can get away with misusing funds or defaulting on your loans even when you have a yacht that can cover it, why would you try and repay?

While this in itself is troubling, the knock-on effects it has are even more so.

When a large debt is written off, the bank must make provisions to cover the losses generated. It does this by using its reserves in the system. This lowers the liquidity or ready cash the bank has on hand.

This increases the likelihood of the bank not having enough money to give out if too many depositors try to make withdrawals simultaneously. Thus, the increased risk of a bank run lowers the trust in the banking system as a whole, which is crucial in a year which has seen the biggest bank failures since 2008.

Another alternative to banks using their reserves is the government stepping in and using taxpayers’ money to cover the written-off debts.

This is both ethically and fiscally problematic. By giving money to banks, the government is essentially pumping more money into the economy. This comes at a time when both the reserve bank and the government are trying to reduce inflation, a problem that arises when too much money chases too few goods.

Increasing the money supply by funding written-off debts directly counteracts this aim.

In a country with staggering inequality and an ever-broadening middle class, the uproar this has caused was inevitable. Imagine being a person trying to make ends meet in a world where inflation keeps pushing up grocery prices, yearning for a home of your own but being unable to afford the exorbitant interest rates, and still diligently paying taxes.

Would you not be indignant when you find that a fraudulent corporations’ debts are not only funded in part by your hard-earned money but also that they worsen your economic reality?

These regulations have, to a degree, transferred the blame of defaults from the borrowers to the bank employees which sanction them.

Ostensibly to discourage banks from making risky loans, the RBI has mandated that when a compromise settlement between a willful defaulter/fraudster and a bank is taking place, a board comprising of the higher-ups in the bank must be created to evaluate the degree to which the employee can be blamed for the default.

While accountability is key, the burden of it seems rather misplaced – it’s like putting the gatekeeper rather than the thief on trial. Certainly, any lapses or misdealing on the part of the bank employee must be repaired, but not while letting the culprit go away scot-free.

Earlier, they would have to be mired in the proceedings of the Debt Recovery Tribunal and could not get another loan for five years.

Now, because a compromise settlement classifies as a ‘restructuring’ of the debt, they can get a loan within a year. Bank employees have bristled at this, with the All India Bank Employees Association (AIBEA) writing that “allowing compromise settlement for accounts classified as fraud or willful defaulters is an affront to the principles of justice and accountability.”

It’s notable that they do not object to the RBI’s policy on the grounds that it increases the pressure on them, rather, they welcome the scrutiny. But it’s the fundamental lack of fairness here that exasperates them most.

To sum up, those who are outraged are not asking for a return to a time when judicial proceedings wind on and borrowers are frequently locked up in debtors’ prisons.

But by signaling leniency towards willful defaulters and fraudsters, the RBI is weakening the institutional guardrails that prevent the breeding of ‘Harold Skimpoles,’ or a race of carefree individuals who, despite being aware of their empty pockets, order a grand dinner and then frolic off, leaving someone else to foot the bill.