Revisiting Credit Basics in Plain and Simple English by RBI Governor at Third Dr Verghese Kurien Memorial Lecture To Give Credit Its Due by Raghuram Rajan The flow of credit relies on the sanctity of the debt contract. A debt contract is one where a borrower, be it a small farmer or the promoter of a large petrochemical plant, raises money with the promise to repay interest and principal according to a specified schedule. If the borrower cannot meet his promise, he is in default. In the standard debt contract, default means the borrower has to make substantial sacrifices, else he would have no incentive to repay .For instance, a defaulting banker in mediaeval Barcelona was given time to repay his debts, during which he was put on a diet of bread and water. At the end of the period, if he could not pay he was beheaded. Today , the borrower typically only forfeits the assets that have been financed, and sometimes personal property too if he is not protected by limited liability , unless he has acted fraudulently . The lender doesnt share in the losses to the full extent because he is not a full managing partner in the enterprise. By agreeing to protect the lender from `downside risk, the borrower gets cheaper financing, which allows him to retain more of the `upside generated if his enterprise is successful. Moreover, he can get money from total strangers, who have no intim ate knowledge of his enterprise or his management capabilities, fully reassured by the fact that they can seize the hard collateral that is available if the borrower defaults. This is why banks offer to finance your car or home loan today at just over 10%, just a couple of percentage points over the policy rate. Eroding the Contract The sanctity of the debt contract has been continuously eroded in India in recent years, not by small borrower but by the large borrower.And this has to change if we are to get banks to finance the enormous infrastructure needs and industrial growth that this country aims to attain. Too many large borrowers see the lender, typically a bank, as holding not a senior debt claim that overrides all other claims when the borrower gets into trouble, but a claim junior to his equity claim. In much of the globe, when a large borrower defaults, he is contrite and desperate to show that the lender should continue to trust him with management of the enterprise. In India, too many large borrowers insist on their divine right to stay in control despite their unwillingness to put in new money . The firm and its many workers, as well as past bank loans, are the hostages in this game of chicken ¬ the promoter threatens to run the enterprise into the ground unless the government, banks, nd regulators make the concessions that are necessary to keep it alive. And if the enterprise regains health, the promoter retains all the upside, forgetting the help he got from the government or the banks ¬ after all, banks should be happy they got some of their money back! No wonder government ministers wor ry about a country where we have many sick companies but no `sick promoters. Risk-Taking Is Good, But... I do not intend in any way to cast as persions on the majority of Indian businesspeople who treat creditors fairly . I also dont want to argue against risk-taking in business. If business does not take risks, we will not get architectural marvels like our new international airports, the `developed-for-India low-cost busi ness model in the telecom sector, or our world-class refineries. Risk-taking inevitably means the possibility of default. An economy where there is no default is an econ omy where promoters and banks are taking too little risk. What I am warning against is the uneven shar ing of risk and returns in enter prise, against all contractual norms established the world over ¬ where promoters have a class of `super eq uity which retains all the upside in good times and very little of the downside in bad times while cred itors, typically public sector banks, hold `junior debt and get none of the fat returns in good times while ab sorbing much of the losses in bad times. What we need is a more balanced system, one that forces the large borrower to share more pain while being a little more friendly to the small borrower. The system should shut down businesses that have no hope of creating value while reviving and preserving those that can add value.And the system should preserve the priority of contracts, giving creditors a greater share and greater control when the enterprise is unable to pay while requiring promoters to give up more. The solution is not more draconian laws, which the large borrower may well circumvent and which may entrap the small borrower, but a more timely and fair application of current laws. We also need bankruptcy courts and turnaround agents. Finally , we need a change in mindset, where the willful or noncooperative defaulter is not lionised as a captain of industry , but justly chastised as a freeloader on the hardworking people of this country.
Posted on: Fri, 28 Nov 2014 06:41:52 +0000
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