Wilful defaults: the financial underbelly of the Indian banking system

A financial underbelly can come to life if firms in an economy have incentives to go broke for profit at a bank's expense instead of to go for profit. According to data from the 2018 Economic Survey, the Indian banking sector has one of the highest percentages of loan assets declared as non-performing assets (NPAs). Only four economies globally have higher NPAs than India. These are Portugal, Italy, Ireland, and Greece. These four, along with Spain, are notorious for their NPAs and are better known by the moniker—PIIGS. Of the total NPAs in the Indian banking sector, 80% are with public-sector banks. Such high NPAs are understandable if the economy was in doldrums as in PIIGS. However, India has among the highest GDP growth rates globally, the stock market is at an all-time high and Indian corporate, in general, are doing well financially. A large portion of the NPAs are from defaults like those of the Vijay Mallyas and Nirav Modis of the world. They have the money but choose not to pay. In finance and economics theory parlance, this is defaulting wilfully.

The very idea of default as a strategy, challenges our common sense and cultural notion of default as a place to avoid. It also challenges academics because economic theory has always underplayed the strategic nature of default. Almost all the existing theories focus on justifiable or legitimate defaults due to financial distress. The lack of attention of wilful default in literature is mostly because default has been treated as straightforward in the standard equilibrium approach of economic theory. Equilibrium models cognize default purely as a financial state in which a firm's debts outweigh its assets. In aggregate, according to these microeconomic models, firms in such Funviable financial positions are forced out of business and other more efficient successors simply take up the market niche left by the exiting firms. In some sense, the equilibrium approach to default is the Darwinian equivalent of "survival of the fittest" theory. Consequently, these equilibrium models deduce that more productive firms are constantly replacing unproductive firms, thereby leading to increased system-wide efficiency and an overall market composed of efficient firms.

Another reason for economists' lack of attention on wilful default is that it is a phenomenon unique to India. And most economic research till recently has been largely U.S.-centric. So, it's not surprising that wilful defaults as a topic of research has been largely ignored in economics and the finance profession. But this “underinvestment” in research on a pertinent and critical economic problem should be a concern for academics and policy-makers in India. Theoretically, businessmen like Vijay Mallya and Nirav Modi exit not as part of a natural selection component of any "survival of the fittest" evolution, but simply because they choose to strategically default on their financial obligations. In the process, they tunnel government's money in public sector banks to their bank accounts in offshore locations. This has been made possible by a unique economic ecosystem in India where banks are largely owned by the government and have episodic, if not rampant, corruption aggravated by a legal system that imparts delayed justice if at all, on wilful defaulters. This toxic troika has brought about an epidemic of sorts of wilful defaults resulting in high NPAs and bracketing us, at least on this measure, with the PIIGS.

Unless banks and regulators find a way to weed out such wilful defaulters, this problem is likely to continue in one form or the other. And in underinvesting and procrastinating about coming up with a research-driven rigorous approach to analyse and weed out wilful defaulters because it is a difficult problem to solve, academics may be kicking the sticky 'can' down the road. Not dealing with this pertinent problem by putting a band-aid on it and hoping that the structural cracks of such siphoning-off of public money would heal with time is procrastination, or at best, wishful thinking. Not addressing the problem today may mean that the public sector banks may have to deal with even worse wilful defaults in the future.

There are largely two different approaches to scrutinising, analysing, and eventually predicting wilful defaults. The first is that each public sector bank designates a specialised department to do the necessary scrutiny of firms' ethical and moral disposition. But who is to say that however skilful these bankers might be, they wouldn't get misled by even shrewder borrowers or worse, wouldn't do it with prejudice or favour. The second approach is for academics and policy-makers to come up with a methodology that is as objective, methodical and thorough as possible, acknowledging the fact upfront that it is not going to be perfect. The methodology may evolve with time but not trying to grapple with the problem because it is a difficult one to solve theoretically and empirically is to pretend that the problem doesn't exist.

In my joint research with Prof. Subramanian at ISB, we find that theoretically the solution may lie in turning to the mechanism by which wilful defaulters resort to transferring the proceeds of a loan into other related group companies or subsidiaries through what are called related party transactions. Both distressed defaulters and wilful defaulters have financial problems, the causes are different. While distressed defaulters experience unexpected business shocks, wilful defaulters systematically siphon-off money to other group companies or subsidiaries. Empirically, when we take the model to data, we find that related party transactions are a significant predictor of wilful defaults.

A related approach that banks can pursue is to come up with a data-driven algorithm that uses historical wilful defaults by corporates as training data to produce a data-driven decision rule to predict strategic defaults. Such data-driven algorithms have been used to predict lot more random outcomes like an election or a baseball game with reasonable precision. Of course, such approaches are not perfect but perfectionism is often cited as the mother of procrastination. And there would always besceptics who would think that all economic theory and quant models are hogwash, but the truth of a proposition is independent of how many people believe it to becorrect. The benefits to investing in studying this problem is substantial for our economy because the ability to predict wilful defaults would help clean the Indian banking industry of the high levels of NPAs. Weeding out such opportunistic behaviour by businesses would impede the existence of a financial underground wherefirms have an incentive to go broke for profit at a bank's expense instead of to go for profit.