Needed, a modern personal insolvency regime

Dwijaraj Bhattacharya/Deepti George | Updated on August 04, 2020

Personal insolvency needs to be treated as a social insurance option. A mechanism which relies on the interaction between creditors and borrowers must be put in place

Many Indian households are likely to experience financial distress in the aftermath of the Covid-19 pandemic. Unemployment rates, according to the Center for Monitoring Indian Economy, increased from around 8 per cent in February to approximately 23 per cent in May 2020. In many cases, especially for migrant workers, the situation has metamorphosed into a humanitarian crisis with even food security on the line. It is likely that many households, especially low-income households (LIH) will not be able to service their outstanding debt to the extent needed once the RBI’s moratorium period is crossed in August 2020.

Since it is unclear whether economic lives will return to pre-Covid levels, it is reasonable to conclude conservatively that the debt-servicing abilities of a significant number of households will continue to experience strain. Thus, there is an imminent need to ensure that mechanisms are put in place to address the impending debt repayment crisis, particularly for those who are poorer and indebted and whose livelihoods may not return to normal.

Restructuring mechanism

Most Indian households have not purchased risk-mitigation products like life and health insurance, despite abundant offerings. There are many reasons for this, but one can conclude from evidence that households often have no option but to rely on credit for consumption smoothening and meeting emergency and unplanned expenses. Many consumers have already contracted (or can be expected to contract) new lines of credit to cope with the Covid-19 induced economic crisis. These new lines of credit are immensely helpful for the household in the short run, but they also impose an additional debt servicing burden, which in turn may lead to severe debt traps if fortunes don’t improve.

Unfortunately, bi-partisan, market-based mechanisms for restructuring of consumer debt are non-existent in India. Even if one is to account for the rare renegotiations in consumer credit products, these are too few and far between to serve as a market practice.

A statutory mechanism for the restructuring or discharge of debt may be the only avenue by which borrowers can seek refuge. The present apparatus to seek protection from the obligation to repay debt that is essentially unserviceable is presented in The Presidency Towns Insolvency Act, 1909 or The Provincial Insolvency Act, 1920. However, these statutes do not, for the most part, allow for any estate protection for debtors (i.e., the ability to retain part of their estate), even for sustenance. It is therefore imperative that Part III of the Insolvency and Bankruptcy Code (IBC), 2016, which deals with personal insolvency, bankruptcy and fresh start processes, be notified expediently.

The IBC introduces protections that prevent the insolvency-related liquidation of an unencumbered dwelling unit and other assets for sustenance and maintenance of profession. Further, for individuals with low income (less than ₹60,000 annually), few assets (worth less than ₹20,000) and without homeownership, the IBC provides for a Fresh Start Process, whereunder debt up to ₹35,000 may be discharged without any impounding of assets. Thus, the IBC is direly needed to provide much-needed relief to the household sector.

Further, without Part III of the IBC, current protections can be provided only through the machinery of the high courts and district courts. This route imposes tremendous uncertainties with respect to time taken till resolution and the legal costs involved, both of which are readily addressed in the provisions of Part III of the IBC. Finally, alongside rescuing borrowers from debt distress, the IBC provides the unique feature of debt rehabilitation, whereby the borrower is able to re-start their credit lives once the distress passes. Given the previously discussed characteristics of LIHs, the necessity of such rehabilitation cannot be understated.

Credit profile

The IBC ensures that the credit profile of an individual in the short term reflects whether he or she has availed any remedies under it and allows providers to decide whether to extend credit to such borrowers. One could argue that individuals may therefore not apply for bankruptcy for fear of future credit denial. However, despite this, Part III of the IBC offers a hitherto unavailable option to a borrower, among the limited social insurance options currently available to her.

The IBC is not a silver bullet to remedy all financial hurdles for LIHs, and neither should it be. The role of state support is undeniable in many cases, including that of natural calamities. It is also unfair to expect creditors to write off loans gone bad due to large unforeseen events. In the absence of weather insurance markets, it may be impossible for the government to step in every time and come to the rescue of households and firms, particularly in events where loss of livelihoods resulted from extraneous events such as weather shocks. The pandemic presents a new and unforeseen risk event in this regard.

Therefore, personal insolvency needs to be treated as a social insurance option. It is imperative that a mechanism which relies on the interaction between creditors and borrowers (ie a market-based mechanism) be put in place. This safety-net, in the form of Part III of the IBC, is thus the need of the hour to safeguard the interests of retail borrowers who may find their debt burden too much to bear in the aftermath of the pandemic.

Bhattacharya is Research Associate and and Deepti George is Head of Policy at Dvara Research

Published on August 04, 2020

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