Need to walk the talk lot more comprehensively

Financial institutions are reeling under a pile of bad loans in an economy that supposedly is the fastest growing not just in South Asia but the world. Loan defaults are usually associated with economic downturns. Most companies and individuals who fail to pay up do so as things go horribly wrong due to factors beyond their control.

Not so in our case. Many large corporates and individuals, despite having the capability to repay, do not. They are alleged to be doing it willfully. It is strategic default of an unusual kind. The usual kind is the case of a borrower who defaults strategically when the asset involved has negative equity. The borrower may be financially capable of making the payments on loans against such an asset, but nevertheless owes more than the asset is worth. The borrower decides that strategic default is a better option than continuing to pay the loan. It provides a means for the owner to mitigate loss when the value of the asset drops below the amount owed on the property.

In case of Bangladesh, the problem is very different. The borrower knows that, following default, recovering the money from them will involve a long legal battle during which the defaulter can even access new money.  The costs of facing the litigation and loss of credit rating may be well worth the money saved by defaulting. On the scale of World Bank's country level governance indicators, Bangladesh ranks low on controlling corruption, improving regulator quality, government effectiveness and rule of law. Shrewd borrowers take undue advantage of the ineffective functioning of economic, legal and political institutions, even when legal suits have been filed against them for debt recovery. This unwillingness to repay is affected more by pecuniary considerations. Nonpecuniary factors such as views about fairness and morality find no place. Apparently, the cost of defaulting strategically increases with the size of the loan, but at a decreasing rate.

Exposure to other people who strategically defaulted increases the propensity to default because it conveys information about the probability of being sued and penalized. This can lead to default contagion because the social stigma associated with default being considered immoral decreases with the number of people defaulting on their loans. This effect may either be due to a clustering of people with similar attitudes or a learning of the actual cost of default or both.

In such a context, the government's initiative to enact a new law—the Finance Company Act 2020--defining willful default is commendable. It marks the beginning of walking the talk we have been hearing for more than a year now on bringing the willful defaulters to task. Identifying willful or habitual defaulters and naming them in public could tighten emotional constraints that restrain people from strategically defaulting. It allows the government, the media, and the financial industry to use moral suasion through naming and shaming to cultivate these emotional constraints in defaulters followed by punitive measures. 

The draft act proposes that a willful default is deemed to have occurred if there is a default in repayment obligations by a company or individual to the lender even when it has the capacity to honor the said obligations, implying  a deliberate intention of not repaying the loan; the funds are not utilized for the specific purpose for which credit was availed but have been diverted for other purposes; when the funds have been siphoned off and not utilized for the purpose for which it was availed and no assets are available which justify the usage of funds; and when the collateral asset against the borrowed funds have been sold off without the knowledge of the lending institution.

The above definitions are in line with international best practice. The one thing it should consider adding is in cases where a letter of comfort or guarantees furnished from a third party by the willfully defaulting units are not honored when they are invoked by the lender, then such a third party is held accountable.  In cases where guarantees furnished by the companies within the Group on behalf of the willfully defaulting units are not honored when invoked by the lenders, such Group companies are also reckoned as willful defaulters.

A couple of other questions need answering before proceeding further:

• Is the legal route the most efficient way? Couldn't the regulators promulgate these definitions through a gazette notification and/or circular?  Getting the law passed, defining the rules and then implementing them is likely to take years and by then the damage done to the financial system could be irreversible. The Reserve Bank of India did this in 2014 through a "Master Circular on Willful Defaulters".
• Why not broaden the scope of the law to cover scheduled banks as well. Bulk (90 percent plus) of the habitual default occurs in case of bank loans.  There are no particular reasons why willful bank loan defaulters should not be subject to the same discipline as willful NBFI defaulters.  In fact, applying it to just a small part of the financial system may have the unintended consequence of shoving more the willful defaulters to banks even more, thereby just shifting and not really addressing the problem.  

The proposed punitive measures include embargoes on travelling abroad, denying any trade license and formation of new companies, not allowing registration of home and vehicles, barring from holding any post in the executive committee of political, social, professional and business organizations and filing criminal cases against the willful defaulters with prior approval from the NBFI's board.

These can be tightened by clarifying that no additional facilities should be granted by any lender to the willful defaulters. In addition, such companies (including their owners or sponsors) where the lenders have identified siphoning or diversion of funds, misrepresentation, falsification of accounts and fraudulent transactions should be debarred from institutional finance from banks and non-bank institutions for a period extending beyond the date of removal of their name from the list of willful defaulters as determined by the regulator. The legal process, wherever warranted, and foreclosure for recovery of dues should be initiated without requiring board approval so that the management of the lending institution can expeditiously initiate criminal proceedings against willful defaulters.

It would be imperative on the part of the banks and NBFIs to put in place a transparent mechanism for the entire process so that the penal provisions are not misused, and the scope of such discretionary powers are kept to the barest minimum. It should also be ensured that a solitary or isolated instance is not made the basis for imposing the penal action. While dealing with willful default, the lenders should consider the track record of the individual or company with reference to its repayment performance to its lenders.

 The author is an economist.