Reserve Bank of India Allows Willful Defaulters and Fraudsters to Compromise with Banks: Implications and Concerns

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

In June 2019, the Reserve Bank of India announced a reversal from its 2023 policy, which severely dealt with willful defaulters and fraudsters published a series of circulars that make these borrowers eligible compromise agreements.

Now even those who have willfully misused the funds lent to them or who refuse to repay loans when they are able to do so are allowed to negotiate and compromise with the banks.

The rationale behind the move is to reduce red tape in the economy and make financial frameworks more borrower-friendly, but it has drawn the ire of banking unions and the general public.

This is understandable for two reasons.

First, it seems fundamentally unfair to treat individuals and companies who have wasted or embezzled funds the same way you would treat a borrower in a really difficult situation.

Second, the impact of this change on financial stability, especially in an environment of high inflation and rising interest rates, could be significant.

Before this change, if the borrower used the funds granted to him illegally (fraud) or refused to pay even though he was able to (willful default), then the bank and the borrower had to go to the debt collection court.

The goal of arbitration, as the innovative name suggests, is to take as much money from the borrower as possible. This process is generally lengthy and agonizing. It is so notorious that it actually discourages people from committing willful omissions or fraud as they would remain involved in lawsuits for years.

A compromise solution initially seems to be a welcome alternative to this bureaucratic money wrangling.

The borrower immediately pays a certain amount of cash. However, this has a downside. A large part of the loan (approx. 70-80%) is “technically” written off. This means that while the amount written off remains “pending” in the borrower’s account and the borrower is legally obligated to pay it, the bank recognizes that repayment is unlikely and agrees not to force the borrower to pay (which is what yes it is). what debt collection courts would tend to do).

The red flag of moral hazard is clearly visible here. When you know you can get away with misusing funds or defaulting on your loans, even if you have a yacht that can cover that, why bother trying to pay off the debt?

While this is worrying in itself, the knock-on effects it has are all the more concerning.

When a large debt is written off, the bank must create provisions to cover the losses incurred. It does this by using its reserves in the system. This reduces the liquidity, or cash, that the bank has at its disposal.

This increases the likelihood that the bank will not have enough funds to withdraw if too many depositors are trying to withdraw at the same time. This increases the bank’s risk run decreases trust in the banking system as a whole, which is crucial in a year that saw the biggest bank failures since 2008.

Another alternative to banks using their reserves is for the state to step in and use taxpayers’ money to cover the written-off debt.

This is both ethically and fiscally problematic. By giving money to the 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 lower inflation, a problem that arises when too much money is chasing few goods.