Tight laws aid recovery

Market Insight

An efficient debt-recovery would make a huge difference to the banking sector's performance. It is time we simplified the legal processes.

On paper, India's legal system is easily understood. The basic framework is 19th century British law. "Upgrades" such as the IT Act 2000 or the Electricity Act 2003, or the Sebi Act are drafted on similar lines to modern British and US law. In practice, enforcing a contract or any other legal recourse by going to court in India, takes an inordinate length of time. That is very disconcerting for somebody who expects US/British speeds.

Perversely, the delays provide a defence mechanism against some types of financial meltdown. The US Subprime crisis illustrates that moral hazard can actually be caused by confidence in the legal system. US institutions lend freely because it is easy to foreclose on defaulting mortgages. They also securitise loans readily for the same reason. In contrast, Indian institutions are conservative due to the lack of legal recourse in defaults. Banks charge higher rates and employ goons since recovery through normal means is impossible. This is not healthy - apart from encouraging criminals, it makes capital more expensive and retards growth.

In the recent past, banks have come under scrutiny from the Supreme Court due to over-enthusiastic recovery agents. There are reliable rumours that credit card issuers could soon be hit with a cap on the rates they can charge as well, citing provisions under the Bombay Money Lenders Act of 1946. That could put the brakes on loans because banks and card issuers will be hamstrung in terms of recovery.

But while the tardy legal system is a hindrance to doing normal business, it does prevent blowouts. The US situation is essentially securitisation gone mad. In this game, a lender creates a portfolio of high-yield/ high-risk loans, and sells it (maybe many times over) after making net-present-value calculations.

Different, complex models are used to judge net present value (NPV). These incorporate assumptions about certain levels of default and resulting total yield. But if default rises beyond acceptable levels and asset prices collapse, it's the kiss of death. US institutions further exacerbated the problems by lending cash to their clients to buy portfolios of securitised subprime loans that they created! This self-referential leverage is crazy. But it makes sense to risk an occasional blow-out by accelerating normal debt-recovery and thereby encouraging lower rates. Say, for example, that a leveraged crisis may knock 1 per cent off GDP for five years in succession. But an efficient debt market could add say, 1.5 per cent to GDP growth for a similar period by offering cheaper credit. Then it's worth risking the crisis for the growth.

Unfortunately we don't have credible guesstimates of this risk:reward equation. It's true that usurious Indian credit card rates lead to lower credit card usage and lower consumption-driven growth. Corporates and house-owners also under-leverage because rates are padded. But how much could rates be cut and how much quicker would the economy grow if the legal system allowed efficient debt-recovery? And, how much would be at risk in a collapse caused by over-leverage inside a more efficient legal system? No answers.

It may not matter in a cyclical boom such as over the past three years. But it could make a tangible difference in a recovery. For example, the 2001-2003 recession may have ended much sooner if rates had been cut more and earlier. Over the long-term, efficient debt-recovery could make a huge difference. Investing in imparting efficiency to legal processes could be very good. If financial institutions find extra-legal recovery routes blocked, they may try to negotiate a reasonable quid-pro-quo. They will cut rates and stop using goons; but the legal recourse for debt-recovery must improve. My guess is that before the legal system is willing to accept the need for faster-track debt-recovery, there will be a credit squeeze that will retard growth for some time.

Over the past two years, banks have seen a bull run on optimistic assessments. Those expectations revolve around enforced expansion of capital bases due to Basel II norms and also the hope of mergers yielding better balance-sheets. Admittedly, credit has expanded very quickly due to the housing boom and higher credit card issuance. Has anybody factored in the possible interplay of lower rates, a more efficient debt-recovery system and the possibly higher risks of blow outs? To the best of my knowledge, no.