The consequences of criminalising cheque bouncing

by Shubho Roy and Ajay Shah

Many countries (e.g. New Zealand, Poland, Germany, Norway) have discontinued paper cheques. In other countries (e.g. the U.K., the U.S.), the use of cheques is declining. But in India, the use of paper cheques in India has stabilised in terms of value and number over the last five years. This is despite the extent to which digital and instantaneous payments are now feasible. Why might this be the case?

Prior to 1988, cheques were primarily used as a tool of payment. In that age, there were delays in clearing. Paper cheques had to be transported to the bank branch where the cheque issuer had an account. In that branch, the issuer's signature would be verified against a sample. If the signatures matched, the balance would be cleared (assuming the issuer had adequate funds). This process took seven working days, even when the issuer and recipient had banks in the same city. If the parties were in different cities, the process would take 15 working days, on average.

Today, a cheque issuer can send a secure document showing that the issuer's bank account has adequate funds to honour the cheque. However, in 1988, there was no such system, and the cheque recipient faced the risk that the issuer was writing a cheque that her account could not honour.

Some technical mistakes can always happen, where a person fails to anticipate the date on which funds are required and there are unpredictable delays in the money moving in and out of the account. Alongside this, many unscrupulous people knowingly wrote bad cheques. This made sellers mistrust cheques and prefer cash. While cash as a payment mechanism has the virtues of instantaneity and privacy, it comes with difficulties on physical security.

The 1988 change of the law

In this setting, the Parliament criminalised the bouncing of cheques in 1988. Now, the cheque writer could be sent to jail if the cheque did not clear. The law also stated that every cheque is presumed to be written to clear a debt. This change helped the recipient of cheques because the recipients did not have to prove any underlying transaction. The recipient only had to demonstrate that the cheque was not honoured.

In 2016, the Supreme Court ratified the practice of using cheques as collateral in the case of Sampelly Satyanarayana Rao v Indian Renewable Energy Development Agency Limited. Sampelly Satyanarana Rao (Mr. Rao) had written post-dated cheques as security for a loan from the Indian Renewable Energy Development Agency (IREDA). Mr. Rao did not take the loan personally but wrote the cheques as a director in the company that borrowed the money. The borrower company failed to pay the instalments when they became due. In response, IREDA (the creditor) initiated criminal proceedings against Mr. Rao under the 1988 law. Mr. Rao defended the claim by stating that the cheques were written before the creditor (IRDEA) disbursed the loan amount. IREDA pointed out that the cheques were deposited after the borrower (the company) had failed to pay the instalments, and therefore, the penal provisions of the 1988 Act applied. The Supreme Court agreed with the creditor and allowed for the criminal prosecution of Mr. Rao. This judgement provides legal certainty to the use of post-dated cheques as security. This date, i.e. 2016, is an important milestone in the journey, over and beyond the amendment of the N. I. Act in 1988.

The role of cheques in India today

The threat of imprisonment restored some faith in cheques. Anecdotally, it seems to have worked well in the initial years after the amendment. Cheques became more acceptable in commercial transactions and helped reduce frictions in economic activity. Many a cheque recipient was willing to take the risk of delivering goods without waiting one or two weeks for a cheque to clear.

These considerations do not exist in the present landscape. Instantaneous payment systems are ubiquitous in India, ranging from small value payments to the largest amounts possible. Any problem of trust between buyers and sellers can be readily solved by resorting to NEFT or RTGS. By this reasoning, the number of cheques written in India should have declined sharply. It has not.

People responded to incentives

Alongide this, the rest of the Indian legal system which enforces contracts works poorly. Ordinarily, a loan dispute would be resolved as a contract dispute through civil law, and, in some cases, bankruptcy law may be involved in situations where the debtor is insolvent. In 2020, in enforcing contracts, India ranked 163 out of 190 countries, while its overall rank was 63 (a difference of 100 ranks). India's rank in resolving insolvency was 52. Hence, creditors are unconfident about ordinary credit enforcement mechanisms.

One strand of credit enforcement systems is seizing assets that are pledged as collateral. This tends to work poorly in India. While the SARFAESI Act of 2002 is reasonably effective in getting collateral into the hands of the lender, many assets are hard to sell. Many land titles have encumbrances, and the land market works poorly, which hinders the recovery rate.

These weaknesses of the ordinary (civil) credit enforcement systems made criminal proceedings under S.138 attractive to creditors. Under S.138, a debtor faces up to two years of imprisonment if the debtor is convicted. In reality, the creditor does not even have to wait for the end of the litigation to get the debtor imprisoned. The debtor can be arrested at the beginning of the litigation so that the debtor can be produced before the court. In some cases, the debtor can also be imprisoned for the duration of trial under S.138. In contrast, a civil case proceeds without the debtor, if the debtor chooses not to appear. Most people will pay up to avoid being imprisoned, which gives heart to creditors.

When faced with legal difficulties around land title, it is better for the creditor to threaten imprisonment, and have the borrower solve the problem of selling the land, instead of seizing collateral and then facing legal difficulties in liquidating them.

As a consequence, after the new law was established in 1988, creditors started using cheques as a security. Creditors frequently demand that the debtor provide post-dated cheques for loan amounts. These cheques are payable deep into the future -- sometimes extending to multiple years. In such cases, both parties are aware that the cheque drawer does not have the money in the bank account at the point in time when the cheque was signed. Creditors sometimes demand a separate cheque for each instalment of loan repayment. Consequently, a debtor for a five-year loan may write 60 post-dated cheques. On a similar note, landlords sometimes asked for post-dated cheques for the payment of rent at multiple time points in the future.

Modern economies do not have a debtors prison: the choice of filing for bankruptcy is always there, in which case the creditor gets a low recovery rate. On one hand, in India, there is no legal framework for personal bankruptcy. When threatened with jail time, the borrower may reach into her web of relationships, and borrow from the community. This increases the resources available to the lender.

Weighing the pros and cons

The introduction of S.138 has thus exerted many complex impacts upon the working of the economy.

An increased level of violence in society

More people go jail, and more threats of incarceration are bandied about. This is a less civilised society.

Increased interest in lending

When lenders are given greater certainty about recoveries, they are likely to be more willing to lend to persons that might otherwise be excluded from the credit market.

Diminished interest in borrowing

When borrowers are shown the possibility of jail time, they will be more cautious and avoid borrowing. That has its own welfare consequences.

Conditions for state failure

The prospect of jail time is a `high stakes' situation where the policing system gets to make decisions which have a high impact upon the life of a citizen. This increases the incentives for corruption.

Hindering the emergence of a modern economy

All advanced economies have moved away from debtor's prison, and evolved civil mechanisms around borrowing, collateral and bankruptcy. These pathways reduce the extent of violence in society and increases user confidence in borrowing.

The threat versus the cash

Jail time is indeed a potent threat and creates strong incentives for the borrower to obtain cash, either by borrowing from someone else or by liquidating opaque assets. But once a person goes to jail, all future payments to the lender are stopped. With more civil processes of collatoral and bankruptcy, there is the strategy of keeping the delinquent active in economic life, and obtaining a stream of cashflows to the lender.

Incentives for policy makers

Lenders that got comfortable with the use of S.138 were less inclined to persuade policy makers of the need for the institutional apparatus of the credit market.

Conclusion

The introduction of S.138 into the N.I. Act in 1988 was a response to a problem of the time. Some other countries, like Taiwan, had also criminalised cheque bouncing. However, most countries have walked back since then because credit systems have improved and the use of cheques have declined. In those countries, cheques are not used as collateral for loans.

There is a strong argument for repealing this section. The consequences of such a repeal will, however, also be far reaching, particularly in the context where the institutional apparatus for contract enforcement remain weak. It is interesting to look at the list, presented above, of the consequences of criminalising cheque bouncing. We can then ask: Which of these would flip around and arise, in reverse, when cheque bouncing is de-criminalised.

Shubho Roy and Ajay Shah are researchers at XKDR Forum.

Get by with a little help from my friends (and shopkeepers): Household borrowing in response to Covid 19

by Renuka Sane and Ajay Shah

The lockdown in the early days of the Covid 19 pandemic in India impacted on on economic activity. Between April and August 2020, 18.9 million salaried people lost their jobs, difficulties were faced by migrant labourers, and small and medium businesses. Deshpande (2020) shows that overall employment dropped sharply post-lockdown, with larger drops for women than men. Household incomes were adversely affected. As an example, survey work by Lee, Sahai, Baylis and Greenstone (2020) shows that two months into the lockdown poor and non-migrant workers in Delhi saw a drop of 57% in their incomes, with 9 out of 10 workers reporting that their weekly income had fallen to zero. Bertrand, Krishnan and Schofield (2020) measure the fraction of households who say they are able to survive on their own for a week, and in April that value was 34% in the overall population and 50% or more for below-median household income.

How would households cope with such a shock? Economic theory suggests that households desire consumption smoothing. One mechanism for consumption smoothing is borrowing. For example, there was an increase in household borrowing after demonetisation (Karmarkar and Narayan, 2020; Wadhwa, 2019; Chakraborty and Sane, 2019). This connects to the working of the financial system. While India has made a lot of progress in ownership of a bank account, and increased electronic payments, access to formal credit remains low.

What do we expect about household borrowings?

Borrowing during the Covid crisis is shaped by three factors:

1. Income transfers: The government of India announced a stimulus package worth Rs.1.7 trillion after the lockdown. This included food security measures as well as direct cash transfers to poor households. This may have helped households deal with the immediate crisis.

2. Low demand: As people were at home owing to the lockdown, demand may have been affected. It is also possible that households saw this job loss as permanent, and hence cut back on expenditures in a way they would not have had they seen this as a temporary disruption. This also fits with the view that precautionary savings increase after a deep crisis (Rajadhyaksha, 2020). However, this may be true for households in the higher income distributions, but is unlikely to be the case for those below median income.

3. Supply constraints: India's financial system has faced difficulties since 2012. This has manifested itself as business failure at ILFS and other financial firms, large and small. Credit growth was decelerating prior to the lockdown. The difficulties for the financial sector increased when the Reserve Bank of India announced a moratorium on all loan repayments for three months from March to May 2020, and then extended it for another three months. These moratoriums made it more difficult for financial firms to assess the credit quality of borrowers. Overall bank credit growth was 5.8% in September 2020 compared to 8.1% in September 2019. From 2018 onwards, when certain borrowers faced supply constraints, they would have had to deleverage (repaying old loans while not getting new ones) or default.

The grand question of the field consists of understanding the economic condition of households in India in 2020, in examining how consumption was held up through new kinds of labour supply and through borrowing, and in obtaining insights into these three distinct economic forces that are in play. In this article, we discover some new facts that contribute towards this overall research agenda.

Methodology

We source data from the Consumer Pyramids Household Survey (CPHS) for the months of May, June, July and August from the years 2016 - 2020. The borrowing data comes from the Aspirational India table within CPHS. Using this we ask three questions:

1. Did households have debt outstanding at the time of the survey? This helps us understand the total number of borrowers in the economy.
2. What are the sources from whom households have outstanding borrowings? This tells us whether households borrow from the formal or the informal sector.
3. What is the purpose for which households have outstanding borrowings? This tells us if households are borrowing for consumption expenditure, for consumer durables, or for running their businesses.

CPHS does not provide information on the value of debt outstanding. We are, therefore, not able to analyse the impact on borrowing on an intensive margin. Our analysis is restricted to understanding the proportion of households borrowing from various sources, for various reasons, i.e. on the extensive margin. Household weights for each wave are provided by CPHS -- these are used to get population estimates.

Results: The number of borrowers

Table 1 presents the number and percentage of households having debt outstanding in the months of May - August in each of the five years. The number of borrower households had been consistently increasing till 2019. In May - August 2016, 12% of the population had debt outstanding. This increased to 50% by 2019. The number, however, fell in 2020 to 45% of the population. The fall has been greater in urban regions than rural.

Table 1: Number and share of borrowers in the population

WAVE	NATIONAL	RURAL	URBAN
	in million	in million	in million
May - Aug 2016	34.8 (12.3%)	22.8 (12.0%)	11.9 (13.0%)
May - Aug 2017	81.9 (28.3%)	56.7 (29.1%)	25.1 (26.6%)
May - Aug 2018	136.0 (45.6%)	94.0 (46.8%)	42.0 (43.0%)
May - Aug 2019	154.7 (50.5%)	105.1 (51.1%)	49.6 (49.4%)
May - Aug 2020	141.6 (45.1%)	99.6 (47.2%)	42.0 (40.7%)

Disentangling explanations: Sources of borrowing

Given that a large proportion of households did not have enough to live on for more than a couple of weeks, we would have expected a huge increase in the number of borrower households. In order to investigate the sources of this drop, we begin by analysing the role of the financial system in the household borrowing story by studying the sources of borrowing.

Table 2 presents the percentage of borrower households borrowing from each source. We find that the biggest drop in borrowing is from banks: in 2019, 26% of borrower households had borrowed from banks - this has dropped to 20% in 2020. The proportion of households borrowing from money lenders has also dropped - from 7% in 2019 to 4% in 2020. The drop in households borrowing from banks and money lenders was higher in urban regions than rural regions. There has been a lot of discussion in India about the increased risk aversion of banks. A fall in the number of borrower households may be a result of this phenomenon.

Table 2: Sources of borrowing

SOURCE	May - Aug 2019 Rural	May - Aug 2019 Urban	May - Aug 2020 Rural	May - Aug 2020 Urban
Banks	26.6%	25.6%	21.9%	15.3%
Money Lenders	7.1%	7.1%	4.6%	3.4%
Employer	0.5%	1.4%	0.5%	1.0%
Relatives/Friends	14.5%	13.3%	21.1%	27.2%
Shops	52.0%	50.7%	57.6%	49.8%

There has been a concurrent rise in the number of households who have borrowed from friends and family from 14% in 2019 to 21% in rural regions, and from 13% to 27% in urban regions. The sharp increase in the borrowing from friends and family suggests that some smoothing of consumption expenditure is likely to have occurred using informal social networks that play an important role in the economic lives of those in developing countries (Munshi, 2014).

Household borrowing from shops increased in rural India - from 52% to 58%, and fell slightly in urban India. It is interesting to recall that Chakraborty and Sane (2019) had found that between the years 2016 and 2018 (i.e. after demonetisation), the biggest rise in borrowing was from shops, especially by those in the lower income deciles. This seems to be true in the current situation as well, especially in rural regions.

In difficult times, it was not banks, money lenders, and employers that mattered. It was friends and family, and the neighbourhood shops. It appears that non-financial firms and cash flow management by the retail supply chain have been more important than financial firms. The connections from the formal financial system to these shops could then be unusually influential.

Disentangling explanations: Purpose of borrowing

Examining the purpose for which households borrow can tell us something about the demand for credit. Table 3 presents the top five reasons for borrowing in 2020, and compares it with 2019.

Table 3: Purpose of borrowing

SOURCE	May - Aug 2019 Rural	May - Aug 2019 Urban	May - Aug 2020 Rural	May - Aug 2020 Urban
Consumption	62.3%	59.8%	70.1%	65.7%
Business	12.9%	9.1%	19.2%	8.2%
Debt Repayment	7.3%	8.8%	9.1%	11.9%
Housing	7.3%	9.7%	2.4%	4.7%
Durables	5.1%	8.6%	1.6%	4.3%
Investments	6.4%	1.9%	0.4%	0.5%

In May-August 2019, 62% of rural and 60% of urban borrower households had borrowed for reasons of consumption expenditure. In May-August 2020, this had risen to 70% and 66% of rural and urban borrower households respectively. This is consistent with the importance of consumption smoothing, and of many households not having enough resources to survive for more than a few weeks. The increase for reasons of consumption expenditure is higher in urban regions. Urban India was more likely to be affected because of both the Covid infections and the intensity of the lockdown than rural India. Income transfers from the government are also likely to have targeted rural households than urban households.

There has been an increase in borrowing for business and debt-repayment reasons in this period as well. The numbers for rolling over debt went from about 9% to 12% of borrower households in urban regions, and from 7% to 9% of borrower households in rural regions. This suggests that households who would otherwise have serviced debt through business or personal income took recourse to borrowing when those cashflows subsided. A personal insolvency law that is able to provide some relief to debtors and allow for restructuring of the larger loans can help alleviate some of this stress.

The fall in the number of borrower households seems to be driven by the fall in the borrowings for housing, durables purchase and investments. It is also likely that large purchases such as housing and durables are made through bank loans. The fall in the borrowings from banks may be a result of a fall in these large durable purchases.

Conclusion

We study the response of households on borrowings during the 2020 lockdown. We do not have data on the value of debt outstanding. We expected that there would be an increase in the number of households that borrow owing to the disruptions to economic activity. However, it is remarkable, that despite the large shock, overall, there has been a reduction in the number of households that borrow. This fall is driven by fewer households borrowing from banks, and fewer households borrowing for housing, and consumer durables purchases. Households continue to borrow for consumption expenditure, business and debt repayment. The most utilised sources of borrowing are friends and family and shops.

This work suggests many interesting possibilities for downstream research. For example, one can study the differences in borrowing patterns between households with different income and wealth profiles, as well as the correlation between sources and purpose of borrowing. It will also be possible to evaluate whether income transfers from the government led to a fall in the number of borrower households. Similarly, one can ask whether different health outcomes play a role in their borrowing outcomes.

The number of households choosing to borrow has been different from what happened after demonetisation. There may be several reasons for this - the magnitude of the disruption, the length of time for which it lasted, the possibility of more permanent impacts on labour markets among others. This leaves us with interesting research possibilities to understand household behaviour and their interaction with financial markets.

References

Ashwini Deshpande (2020), The Covid-19 Pandemic and Lockdown: First Effects on Gender Gaps in Employment and Domestic Work in India, Working Paper 30, Ashoka University.

Azim Premji University (2019), "State of Working India 2019", Technical Report, Centre for Sustainable Employment.

Kaivan Munshi (2014), "Community Networks and the Process of Development", Journal of Economic Perspectives, 28(4), pp: 49-76.

Kenneth Lee, Harshil Sahai, Patrick Baylis, and Michael Greenstone (2020), "Job Loss and Behavioral Change: The Unprecedented Effects of the India Lockdown in Delhi", Working Paper, EPIC India.

Marianne Bertrand, Kaushik Krishnan, and Heather Schofield (2020), "How are Indian households coping under the COVID-19 lockdown? 8 key findings", Rustandy Centre for Social Sector Innovation, Chicago Booth.

Niranjan Rajadhyaksha (2020), "The covid shock could alter people's financial priorities", Livemint, 5 May 2020.

Sagar Wadhwa (2019), "Impact of demonetization on household consumption in India, Working paper.

Subhamoy Chakraborty and Renuka Sane (2019), "Household debt over time", The Leap Blog, 24 May 2019.

Sudipto Karmarkar and Abhinav Narayanan (2020), "Do households care about cash? Exploring the heterogeneous effects of India's demonetization", Journal of Asian Economics, 69.

 

Sane is a researcher at the National Institute of Public Finance and Policy, Shah is an independent scholar. We thank four anonymous referees, Kaushik Krishnan, Radhika Pandey and Anjali Sharma for useful comments.

Chennai 2015: A novel approach to measuring the impact of a natural disaster

by Ila Patnaik, Renuka Sane, Ajay Shah.

In November and December 2015, the city of Chennai in the Southern Indian state of Tamil Nadu, got heavily flooded owing to unprecedented rainfall. With a population of a little more than 7.1 million people, Chennai is one of the major urban centers of South India, and one of the four important metropolitan cities in India. The flooding is estimated to have led to the loss of more than 500 lives, and damages of about US $3 billion, making it the world's eighth most expensive natural disaster in 2015. In this paper we evaluate the impact of this event for households in Chennai.

Natural disasters, such as the Chennai floods, are important shocks which can influence all parts of the income distribution. In the aftermath of such a natural disaster, the issues of consumption smoothing, liquidity constraints and financial resilience play out. Natural disasters are important in their own right, as we need to understand more about the turmoil faced by households in such states of nature. All governments engage in redistribution in the aftermath of a natural disaster. This motivates research on studying the impacts of natural disasters. Natural disasters are also an opportunity to obtain insights into the economics of household, through observation of households when confronted with such a large shock.

Many researchers have gone into the field after a natural disaster has taken place, and produced evidence about health, income, consumption, and financial conditions in the aftermath of the disaster. But such research does not offer insights into the causal impact of the event as adequate information gathering about baseline conditions, before the event, is lacking.

When panel data about households is present, we observe households before and after the natural disaster. This makes possible the analysis of the adverse impact upon affected households, while additionally observing controls. The constraint in such research has been the time elapsed between two consecutive observations of each household. As an example, even if a panel is measured once a year, there would be many months of elapsed time between the two measurement dates that bracket a disaster event.

In a new NIPFP working paper, Chennai 2015: A novel approach to measuring the impact of a natural disaster we exploit the new opportunities for measurement which flow from the CMIE Consumer Pyramids Household Survey ("CPHS"), which measures a panel of 170,000 households across India. Each household is met with three times a year. There is thus a period of four months, across which the household is measured twice, within which each natural disaster lies. We setup difference-in-difference estimation where households in Chennai are the ``treatment'' group and unaffected households in the rest of the state of Tamil Nadu are the ``control'' group. As households in Chennai are among the more affluent ones in Tamil Nadu, the raw dataset has poor match balance, and we address this problem by also performing matched DiD analysis.

We investigate three questions. First, we evaluate the impact of a flood on household income and consumption expenditure. It is possible that a disaster leads to declines in household income and expenditures owing to the destruction. However, it is also possible that households increase their spending to cope with the disaster, or replace capital stock. For example, some household activities, such as cooking, would shift from internal production to purchases from external providers, which would augment demand for certain goods and services. Households would start buying goods and services for reconstruction almost immediately after the destruction. Large scale expenditures on relief and reconstruction by the Indian state would bolster the local economy.

We find that there was no statistically significant impact on household income during the flood months. Households in Chennai, however, saw a 32% increase in consumption expenditure relative to the non-affected districts. The largest percentage increases in expenditure were seen on health, and power and fuel.

A key figure is shown above. The dotted line is for the controls and the deep green line is for households in Chennai. In both cases, what is shown is the monthly expenditure per person. The vertical black lines bracket the flood events.

At the outset, the households observed in Chennai are, on average, more affluent than the controls. Roughly speaking, we do have parallel trends in the period prior to the flood. During the flood, there was a large surge in expenditure which runs for many months. After that, consumption went down, to a point where the Chennai households were now comparable with those seen in the rest of Tamil Nadu.

Second, we evaluate the variation in the change in expenditure for different households. The adverse impact upon persons who live in structures with inferior structural strength is likely to be larger. We categorise households as more vulnerable, or more financially constrained, through various characteristics such as not having a concrete roof, or not having modern finance (such as life insurance, mutual funds, equity market participation), or not having durable goods (such as ACs, refrigerators etc). We find that the consumption expenditure of the these weaker households increases by a smaller amount than those not financially constrained. This might mean more hardship, and a higher inability to cope with catastrophic events.

Third, we evaluate the mechanism that households use to finance the higher consumption. Households could either draw down their savings, or increase their borrowings to finance expenditures. Our analysis suggests that relative to the control group, fewer households in Chennai saved, borrowed, or purchased assets, in the period after the floods. This suggests that reduced savings and reduced purchase of assets was the channel through which the consumption surge was financed. In our data, after about a year, the consumption surge ended, and was followed by a further decline in consumption. This may be consistent with households refocusing on repairing their balance sheet.

Natural disasters kill around 90,000 people and affect close to 160 million people worldwide. The frequency and intensity of disasters are expected to increase with global warming. Greater understanding is required about how natural disasters impact economic outcomes, so that better public and private responses may be designed. The contribution of this paper lies in bringing new tools of measurement (panel data, three times a year, matched DiD) to bear on an important problem (natural disasters) and discover the phenomena that are at work. The novel estimation strategy shown here can now be applied for many natural disasters in India. Over time, a body of work can develop of this nature, through which more abstract insights can be obtained.



The authors are researchers at NIPFP.

Anticipating India’s New Personal Insolvency and Bankruptcy Regime

by Adam Feibelman.

The Insolvency and Bankruptcy Code has been in force for commercial debtors for over a year, and it has already been employed in over two thousand cases, including some cases that involve large non-performing loans clogging the banking system. These cases have generated numerous important questions of law and policy, and thus the IBC has become a regular and important topic of news, discussion, and commentary within the country.

Meanwhile, there has been hardly any public discussion or commentary about the personal insolvency and bankruptcy provisions of the Code. While the provisions for personal debtors have not gone into effect, the nearly complete lack of attention to portions of the Code covering personal debtors is puzzling. The Insolvency and Bankruptcy Board of India (IBBI) has given clear indications that it is planning to notify those provisions in the relatively new future. Those provisions will introduce a new and complex system of legal tools for citizens across India’s financial spectrum and their lenders, dramatically expanding the global scope of personal bankruptcy and insolvency law by over 1.3 billion people. It is surprising and unsettling that fundamental questions about the purpose and likely impact of these provisions remain largely unaddressed in public discourse.

My working paper, Anticipating the Function and Impact of India’s New Personal Insolvency and Bankruptcy Regime, aims to contribute to discussion of the new personal insolvency and bankruptcy regime by describing it in some detail; analyzing the goals of policymakers who drafted and enacted the regime; assessing the design of the regime in light of those goals; and anticipating the function and impact of the law as enacted.

Provisions of the IBC for Personal Debtors

The Code’s provisions for personal debtors represent a unique combination of approaches from other jurisdictions with some distinct features that harmonize it with the provisions for commercial debtors and others that are designed specifically for the Indian context. The Code provides a “fresh start” chapter for debtors with relatively low income (less than 60,000 rupees), few assets (less than 20,000 “non-excluded” assets), low levels of debt (less than 35,000 rupees), and who do not own their own home. Excluded assets include tools, equipment, books, and vehicles of personal or business use; basic household goods, furniture, and equipment; certain personal ornaments of religious significance; life insurance policies or pension plans; and a dwelling unit up to a value to be determined by the Board. The fresh start chapter simply discharges the debtor’s unsecured debts; it does not require that debtors give up any assets or income to unsecured creditors. Thus, it can be thought of as analogous to a loan waiver regime. It is extremely difficult to anticipate how many individuals in the country who have some debt would be eligible under this chapter, but it could cover significant numbers of borrowers from micro-finance institutions and informal lenders.

Those ineligible for the fresh start chapter will be eligible to file under the Code’s insolvency chapter, which requires debtors to propose a plan of repayment to their creditors and then complete the plan to be entitled to a discharge of their remaining unsecured debt. Unlike the fresh start chapter, creditors can file an application to initiate an involuntary insolvency case for their debtors; they can do so if their debtors default on a payment and fail to timely respond to a demand for payment. In any event, three-fourths of creditors must vote to approve a debtor’s repayment plan, which must provide a minimum budget to the debtor and allow the debtor to retain excluded assets. If creditors fail to approve a debtor’s repayment plan or if the debtor fails to complete an approved plan, the debtor is then eligible for bankruptcy under the Code, which can be initiated by either the debtor or any of the debtor’s creditors. The bankruptcy provisions require the debtor to give unsecured creditors his or her non-excluded assets and then allow for the discharge of the balance of unsecured debts. For the most part, none of the chapters of the Code disrupt secured creditors rights.

Policymakers' Goals

There is relatively little in the public record about the precise goals that policymakers had in mind in designing and adopting the personal insolvency and bankruptcy provisions of the Code. An initial interim report of the Bankruptcy Law Reforms Committee that was charged by the Indian Parliament to propose and draft the new Code briefly noted the need for changes to the personal insolvency laws to address the financial distress of micro, small, and medium enterprises, most of which are sole proprietorships or benefit from personal financial guarantees. The Committee did include broadly applicable provisions for personal insolvency and bankruptcy in its draft legislation, but its final report did not explain the underlying motivation for its work in this area or the social or economic need for the new provisions. It noted only "the importance of such borrowers in the economy," and that, under the preexisting framework, creditors often had difficulty recovering from individuals and often resorted to coercive debt collection, which compounded the social costs of indebtedness. It appears that, to the extent that policymakers considered non-business debtors in drafting and enacting the Code, their primary goal was to promote increased consumer lending in the economy and, secondarily, to provide some degree of protection to individuals in financial distress, especially from aggressive debt collection.

Thus, unlike the provisions for corporate debtors under the new Code, the provisions for personal insolvency and bankruptcy do not appear to have been driven by acute economic or financial conditions. This is noteworthy because countries that have adopted or reformed their consumer insolvency regimes in recent decades have tended to do so in the wake of consumer financial crises or dramatically expanding consumer financial markets. Countries across Europe and elsewhere -- including Hong Kong, South Korea, Israel, and Indonesia -- have adopted or reformed their personal insolvency regimes under such circumstances in the last two decades. While the amount of consumer debt in India has increased significantly in recent decades, and instances of household over-indebtedness appear to be growing, it has not reached levels that suggest systemic vulnerability or a looming threat of household financial crisis. Aside from the ongoing financial travails of farmers in certain regions, a spike in financial distress in some sectors due to the recent demonetization, and a generally acknowledged problem of aggressive debt collection practices across the country, there does not appear to be an emerging crisis of intractable over-indebtedness among individuals and households in India.

Anticipating Function and Impact

The IBC appears to represent a rare instance of a country adopting or modernizing a personal insolvency or bankruptcy regime at a relatively early stage in the development of a consumer financial market, before one is acutely necessary. Doing so avoids costs of responding too late, after consumer financial markets have over-heated. It may also have a beneficial effect on the development of those markets in the first place. Especially since the recent global financial crisis of 2008-10, scholars and policymakers around the globe have begun to appreciate that a personal insolvency or bankruptcy regime is an important component of the institutional framework for consumer credit markets. If properly designed and operated, such a regime can help promote a stable market for consumer credit, making creditors more willing to lend and individuals more willing to borrow, disciplining both, reducing the social costs of consumer financial distress and perhaps the amount of household over-indebtedness in the economy as well.

But such potentially beneficial effects likely depend on a system that improves or accelerates creditors’ insolvency state returns, or at least makes their losses relatively predictable, and that effectively insures individuals against the risk of over-indebtedness without creating incentives for them to act opportunistically or recklessly. It is not clear how well the provisions for personal insolvency and bankruptcy under the Code as enacted will serve these functions, and there are some causes for concern. Certain aspects of the institutional design may exacerbate inter-creditor conflicts, for example, by enabling individual creditors to easily initiate a case and by requiring majority votes among creditors to approve repayment plans. The regime’s reliance on negotiated repayment plans may also limit the predictability of outcomes.

While the fresh start process for individuals with low incomes, few assets, and relatively little debt, is designed to provide a robust insurance function, the insolvency provisions that apply to all other debtors provide much more limited protection for individual debtors. To the extent that there is an effort to target fresh start relief to debtors who need it most, i.e., those who genuinely cannot repay a significant amount of their debt, it is done rather bluntly through the narrow eligibility requirements for the fresh start provisions. The insurance function of insolvency or bankruptcy law can be particularly important to debtors, including those with business-related debts, who have income and assets to protect or who have significant amounts of debt, most of whom would ineligible for a fresh start. The bankruptcy chapter of the new Code promises to provide some meaningful debt relief to such debtors, but they must first go through the insolvency process, which requires a plan of repayment subject to creditor approval, during which the debtor is allotted only a minimum budget, and which formally ensures only a minimum level of relief or protection. Added to which, it is likely that large segments of the population of individual debtors covered by the law will not have sufficient information about the law to utilize it, will face logistical challenges even if they do have sufficient information, or will be deterred by stigma or other reputational concerns.

It is possible, therefore, that a significant portion of debtors in financial distress will not voluntarily use the new insolvency and bankruptcy regime and that it will primarily be employed as a debt collection tool for creditors. If so, the scope of the insurance function of the new system may not end up providing sufficient relief to individual debtors who become mired in debt, may not promote risk-taking entrepreneurial activity, and may not provide a meaningful safety valve to developing consumer financial markets.

Time to Plan, Prepare

To be sure, these concerns are highly speculative, and the last year of activity under the new IBC for commercial debtors has shown that it is too easy to make dire predictions about the challenges facing the new law. Yet, the stakeholders of the new personal insolvency and bankruptcy regime have the relative luxury of some time to prepare for the operation of that part of the Code. Hopefully, policymakers have begun to anticipate some of the potential macroeconomic effects of a newly available, robust regime for personal insolvencies and bankruptcies and consumer lenders have begun thinking seriously about how they might be affected by the new law. Ideally, policymakers are also considering how to disseminate information to individuals and households about the personal insolvency and bankruptcy provisions of the Code that will soon become available so that they can make informed decisions about whether, when, and how to employ it.

 

Adam Feibelman is a Professor of Law at Tulane University, he has been a visiting scholar at National Law School of India University, Bangalore, and the Center for Law and Policy Research.

The size of personal bank credit in India

by Renuka Sane and Anjali Sharma.

In May, 2016, the Insolvency and Bankruptcy Code, 2016 (IBC) law was passed by Parliament and received Presidential assent. The law consists of provisions for both corporate and personal insolvency. However, only the corporate insolvency provisions of the law have been notified and are being implemented. The rapid implementation of the corporate insolvency provisions is largely a response to the policy discourse on the non-performing asset (NPA) problem of the banking sector.

In this article, we turn our attention to personal credit extended by banks, with a view to informing policy actions on the personal insolvency provisions of the IBC. While banks are just one source of personal credit amidst a variety of institutional and non-institutional sources, they are the largest "formal" source of credit, and therefore, the first likely users of the insolvency provisions. Understanding the nature and composition of personal credit extended by banks has implications for effectively designing the procedural aspects of of insolvency resolution under the Code, as well as the institutions that enable the resolution. The decisions surrounding personal insolvency can help lay the foundations for a healthy market for individual credit.

Bank credit to the HH sector

We use the data from the Quarterly BSR-1: Outstanding Credit of Scheduled Commercial Banks released by the RBI. This is a quarterly data series, from March, 2014 till September, 2016, which provides the composition of bank lending by organisation, occupation, loan size, interest rate bands and regions. RBI classifies household (HH) sector credit into three categories. These are credit to: (1) individual borrowers, (2) proprietary concerns, joint families and unregistered partnerships, and (3) joint liability groups (JLG), NGOs and trusts. The data gives us the following details on the size and composition of lending to this sector:

1. HH sector credit is large, both in terms of value and accounts.

   In September, 2016, credit to the HH sector was Rs. 32.2 trillion, 44.3% of the total credit given by banks. In terms of number of loan accounts, HH sector accounts were 98% of the total accounts of the banking system (Table 1). Within the HH sector, credit to single individual borrowers was the largest component, both in terms of value and in terms of accounts.

Table 1: Household sector credit in India

	Loan accounts	Loan value
Categories	(million)	(Rs. trillion)
Total bank credit	143.7	72.7
O/w credit to HH sector	140.2	32.2
- Individuals	134.3	25.2
- Proprietors/ partnerships	3.0	6.3
- JLGs, NGO, Trusts	2.9	0.7
Source: RBI, Quarterly BSR I, Table 1.6

2. Bank credit to HH sector is growing at a faster rate than credit to the corporate sector.

   In the last six quarters, from Q1 2015 to Q2 2016, bank credit to the HH sector has seen an average quarter-on-quarter (Q-o-Q) growth of 3%. By contrast, in the same period, bank credit to non-HH sectors has only seen an average Q-o-Q growth of 0.3%.

3. Bulk of HH sector credit is given as agri loans and personal loans.

   Personal loans (mostly in the form of secured housing and vehicle loans) and agri loans account for Rs. 22 trillion or 67% of the total bank credit to the HH sector. Average loan sizes are relatively small, Rs. 1.2 lakhs per loan for agriculture and Rs. 2.6 lakhs per loan for personal loans.

   The remaining 33% is spread mainly across three sectors: industries (12%), trade and transport (13%) and professional services (6%). These loans are in the nature of business loans. Within industries, most loans are given to proprietors and partnerships, and at an average of Rs. 9.3 lakhs loan size, are relatively large. In trade, transport and services, average loan size is between Rs. 3.5 to Rs. 5 lakhs per loan.

4. Southern and western regions account for more than 60% of agri and personal loans, by value and by accounts.

   38% of agri and personal loans by value, and 46% of the loan accounts, are in the southern region. 24% of loan value and 19% of loan accounts are in the western region. Two states: Tamil Nadu and Maharashtra account for 40% of the loan accounts and 30% of the loan value.

5. Agri loans are given mainly in rural and semi-urban centers while personal loans are given mainly in urban and metropolitan centers.

   Around 85% of agri loan accounts and 72% of the loans by value are given in rural and semi-urban centers. These are places with population less than 0.1 mn. In case of personal loans, 58% of loan accounts and 51% of loans by value are given in metropolitan areas. These are centers with population of 1 mn or more.

6. Agri credit is largely short tenure whereas personal loans are medium to long tenure.

   70% of agri credit is given in the form of cash credit or as demand loans. In contrast, more than 80% of personal loans are medium to long tenure loans.

7. The interest rate distribution of agri and personal loans suggests that, at an aggregate level, there is limited margin for NPAs

   Table 2 shows the distribution of agri and personal loans by interest rate ranges. A comparison of the lending rates with the marginal cost of lending rate (MCLR) for State Bank of India from September, 2016 shows that the margin available for NPAs is limited. The short term MCLR, relevant for agri loans, is 9.05%. Around 56% of agri loans, are in the 6 - 11% lending rate category, suggesting a less than 2% room for NPAs. Similarly, the MCLR relevant for personal loans is 9.25%. 67% of personal loans are in the 6 - 11% lending rate category, suggesting a less than 1.75% room for NPAs.




Table 2: Agri and personal loan lending rates

Lending rate	% agri-loans	% personal loans
Less than 9%	25%	5%
9% - less than 11%	31%	62%
11% - less than 13%	32%	16%
Above 13%	12%	17%
Source: RBI, Quarterly BSR I, Table 3.3

8. Banks have limited mechanisms for enforcement.

   Currently, banks can avail of SARFAESI for resolving secured loans. However, for individual debtors it is used more as a deterrent than an actual enforcement mechanism. DRTs, with their threshold of Rs. 10 lakhs, are available only to the 6-7% of personal credit loan accounts which meet the threshold. For the remaining segments of personal credit, the only mechanism available is the slow and costly Civil Court system. Some banks use the provisions of the Arbitration and Conciliation Act, 1996 for recovery. However, the enforcement of arbitration awards relies on the Civil Court system. There is no collective resolution process available to deal with an individual with a portfolio of loans. Each lender has to pursue its recovery action separately. This proves to be inefficient and costly.

In summary, the data tells us four important facts about personal credit given by banks. First that it is diverse, in terms of borrower profile, loan profile, and geographical spread. Second, it is growing at a faster rate than overall bank credit, given the slowdown in corporate credit and banks increased focus on extending personal credit. Third, the difference between lending rates and marginal cost of lending for this segment is narrow, leaving a limited margin for NPAs. Any deterioration in credit quality of these loans will spell trouble for the banks. Fourth, the mechanisms for recovery are inadequate.

Implications for IBC implementation

The size, and nature of personal credit extended by banks implications for:

The design of IBC resolution procedures:

Most personal loans are secured loans, and banks might continue to use SARFAESI for recovery action on them. IBC may be used mostly in cases where a debtor has multiple unsecured loans, or where the debtor wishes to file for protection under the Code.

A large proportion of agricultural loans are given to low income households. It is possible that many of them will qualify for the fresh start. As most of these loans are in rural and semi-urban areas, design of access will be important for these households to be able to apply for such a waiver.

For those loans that do come to the IBC, the IRP needs to be aligned with the borrowers' profile. A resolution procedure for an individual borrower with low value loans, needs to be simple, low cost and time effective. A simple form-based resolution mechanism, that requires little or no adjudication, may be desirable here. In contrast, resolution procedure for a large borrower or a proprietor may be closer in design to the process for a small company.

On reach, procedure, cost structure and role of the DRTs:

The size of the loans, their complexity, and their geographical spread will need to shape resourcing decisions of the DRTs. This will, in turn, decide their effectiveness as the adjudicating authority for personal insolvency cases. Today DRTs are designed to deal with bank loans above Rs. 10 lakhs. There are only 65 lakh loan accounts in this size threshold in the entire banking system. In contrast, there are 14 crore HH loan accounts, and their average size is Rs. 2.3 lakhs. To effectively deal with resolution of such loans, the DRT rules of procedure, reach, infrastructure, as well as their use of technology for case management, will require a comprehensive re-think.

On how the market for RPs may develop:

The role of RPs, as well as how the RP profession evolves for personal insolvency cases, will be critical. It is likely that, for high value loans, a market for private RPs, concentrated in urban and metropolitan centers, will develop organically. However, for small sized loans, which are geographically dispersed, the question of who will be the RPs and what role they will perform will require assessment, and perhaps even policy action. Further, even when RPs are identified, the process for their licensing, training and monitoring will need to be carefully formulated.

On design of IUs, their accessibility and cost
structures:

The institution of Information Utilities (IUs) is a core component of IBC design. The IUs are expected to facilitate the digitisation of credit transactions, and give such digital records sanctity as evidence in courts of law. Information in an IU can be used for establishing default, and initiating insolvency resolution processes. The structure of IUs, their mechanisms for accepting personal credit related information, and their standards of service will need to be aligned with the need to digitise a large number of small valued loan accounts given to individuals.

On the role of the Insolvency and Bankruptcy Board of India (IBBI):

For personal insolvency, one of the biggest challenges for the IBBI, will be dealing with consumer protection issues. Individual debtors will be vulnerable to biased advice on whether to file for insolvency, the process guiding the filing, and the process for resolution. The IBBI will have to step up to the challenge of protecting customer interests from misaligned incentives that stem from high powered sales practices that have plagued other sectors of the retail financial market.

Conclusion

The design of personal insolvency systems is a complex problem, with challenges that are completely different from those faced by corporate insolvency systems. This article has discussed only the market for bank credit. There will be a larger category of lenders, including money-lenders and friends and family, that may at some point wish to use the provisions under the IBC. Given the size and complexity of the personal credit market, and the paucity of effective recovery mechanisms, there is need for carefully planning and implementing the personal insolvency law sections of the IBC. This is unlike the approach followed for implementing corporate insolvency provisions where speed of implementation has been prioritised.

 

Renuka Sane is a researcher at the Indian Statistical Institute, Delhi and Anjali Sharma is a researcher at the Finance Research Group at IGIDR, Mumbai.