In November last year, Raghuram Rajan, the governor of the Reserve Bank of India, made a very important speech, in which he discussed the inequality between the small and the big borrowers, when it came to recovering loans they have defaulted on.
As Rajan said: “The SARFAESI (Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests) Act of 2002 is, by the standards of most countries, very pro-creditor as it is written…But its full force is felt by the small entrepreneur who does not have the wherewithal to hire expensive lawyers or move the courts, even while the influential promoter once again escapes its rigour. The small entrepreneur’s assets are repossessed quickly and sold, extinguishing many a promising business that could do with a little support from bankers.”
The promoters of big companies on the other hand are able to hire expensive lawyers and get away with it. Though the nation has to bear the cost of their actions. As Rajan had said: “As just one measure, the total write-offs of loans made by the commercial banks in the last five years is Rs 1,61,018 crore, which is 1.27% of GDP. Of course, some of this amount will be recovered, but given the size of stressed assets in the system, there will be more write-offs to come. To put these amounts in perspective – thousands of crore often become meaningless to the lay person – 1.27% of GDP would have allowed 1.5 million of the poorest children to get a full university degree from the top private universities in the country, all expenses paid.”
The trouble is that this is how small borrowers have been treated through much of history. In Coined—The Rich Life of Money and How Its History Has Shaped Us, Kabir Sehgal writes: “Interest bearing loans predated the invention of coins by thousands of years. Around 5000 BC, in what is now known as the Middle East, various types of debt instruments emerged..Interest bearing loans started with agriculture and farming: seeds,nuts, grains, and cows borrowed by destitute farmers who repaid the loan with interest—in the form of the surplus from their harvest.”
And what happened if these farmers did not repay? “Declaring personal bankruptcy wasn’t an option, so there was some creative license in making payments…There were even instances of men giving up their wives or sons to avoid interest payments…A debt contract effectively turned a person into an object or commodity to settle an account, contorting the familial sphere into the commercial one,” writes Sehgal.
In fact, debt prisons were the order of the day through much of human history. It was a common practice even in ancient Rome. As Sehgal points out: “During the Roman Empire, a creditor could arrest the debtor for debt delinquency and haul him into court. If guilty, the debtor could land in a private jail and after sixty days become a slave, a bonded laborer, or even be killed. Though uncommon, creditors were allowed to cut up a debtor’s body into chunks commensurate with the debt owed.” It was that bad. Debtors prisons continued in the Western world through much of the nineteenth century. The United States got around to banning them only in 1869. “In 1830, more than ten thousand people were imprisoned in New York debt prisons. Many times the debts were minimal. In Philadelphia, thirty inmates had debts outstanding of not more than a dollar. There were five people imprisoned for debt delinquency for every one put away for violent offense,” writes Sehgal.
In contrast, some of the biggest borrowers like Kings and governments have gotten away with huge defaults, direct as well as indirect, through the course of history. An indirect default happens when a government creates inflation by printing money and in the process ends up eroding the value of money. This means that when it repays debt, it is actually paying back money which is worth a lot less than it was in the past. And this is nothing but an indirect default.
What this clearly tells us is that the small borrower has always had a tougher time in comparison to the large borrower. And this should not be the case. As Rajan put it in his November speech: “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.”
In fact, research shows that this even has an impact on the amount of innovation that happens in a country. As Rajan put it: “A draconian law does perhaps as much damage as a weak law, not just because it results in a loss of value on default but also because it diminishes the incentive to take risk. For think of a mediaeval businessman who knows he will be imprisoned or even beheaded if he defaults. What incentive will he have to engage in innovative but risky business? Is it any wonder that business was very conservative then? Indeed, Viral Acharya of NYU and Krishnamurthi Subramanian of ISB show in a compelling study that innovation is lower in countries with much stricter creditor rights. Or put differently, the solution to our current problems is not to make the laws even more draconian but to see how we can get more equitable and efficiency-enhancing sharing of losses on default.”
And this is something worth thinking about.
(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)
The column originally appeared on Firstpost on Apr 22, 2015