In 1999, the Reserve Bank of India (RBI) introduced “wilful” and “non-wilful” as classifications of defaulters. This was presumably done to separate promoters who were deliberately gaming the system from those who had genuinely fallen on bad times. On the surface, the term helps us place defaults in context, but actually, it does very little to help with understanding the issue of non-performing assets (NPA).

According to the RBI’ most recent circular, wilful default needs to fulfil the conditions of any one of the following:

1. A company has defaulted AND has the ability to pay.
2. A company has defaulted AND has not used the loan for its sanctioned purpose
3. A company has defaulted AND has siphoned off or diverted the loan amount so that it is not used for its sanctioned purpose
4. A company has defaulted AND has sold off or removed all fixed assets (land, property, jet planes etc) that were used to back the loan without the bank’s knowledge.

A wilful defaulter is barred from further loans, its directors have to resign from any and all company boards and it cannot enter a joint venture for five years. The Securities and Exchange Board of India (SEBI), which regulates the securities markets, is expected to come out with a notification that bars wilful defaulters from accessing the stock market and obtaining an intermediary license, as well. The RBI’s Wilful Defaulter And Defaulting Borrowers’ List suggests wilful defaults are only a fraction of the total bad loans in the banking sector.

An error in classification is not only serious, it is also almost irreversible. If the bank that has wrongly classified a company as a wilful defaulter is state-owned, the borrower can file a writ-petition and prove its innocence in court. If, however, the bank is privately owned, there is no scope for a writ petition as these can only be filed against the State. Given the average pace of justice in India, it is only slightly worse to be labelled a wilful defaulter by a private bank, in which case a company could sue for defamation.

The classification of the wilful defaulter is a telling example of what’s going wrong at a systemic level. Bhargavi Zaveri, a researcher at the National Institute of Public Finance and Policy, says the wilful defaulter classification is a fictitious one. “A defaulted loan is a bad asset for the bank. It doesn’t matter if it was wilful or not,” she said. It makes no difference to a bank whether a default is owing to some malafide activity or genuine economic distress.

A 2014 editorial by Ajay Shah in The Indian Express explains how the wilful defaulter classification is against the principles of liberal democracy since it transfers the coercive power of the state — which is needed to enforce contracts — to private entities:

“RBI’s approach to ‘wilful default’ involves a bank P which determines that your default is ‘wilful’. Once this is done, subordinated legislation issued by RBI forces all banks to punish you. P gives you a bad name and then all banks Q are forced (by RBI regulations) to hang you. The formal processes of enforcement are missing: non-State actors lack appropriate skills and incentives when it comes to justice. There is no mechanism for judicial review. RBI’s regulation on wilful defaulters gives non-State actors the ability to wield the coercive power of the State, without adequate checks and balances. This violates the rule of law.”

Even if wilful/non-wilful is considered a valid distinction for default, the entire process of labelling someone a wilful defaulter is fraught with subjectiveness. “The RBI doesn’t mandate banks to label every wilful defaulter they have as such,” said Zaveri. “The bank can choose which of their wilful defaulters to recognise and there are no consequences for a bank if it chooses not to recognise a wilful defaulter as wilful.”

The bank brings a list of wilful defaulters to a committee of senior bank functionaries. This committee decides which names on the list should receive the classification. This decision is then reviewed and confirmed by a senior committee that also includes some independent members. The process is not overseen by the regulator. It is open to discretion, manipulation and corruption, leading to instances of genuine wilful default not being classified and vice versa.

According to a corporate default expert who did not wish to be named, a bank should monitor its loans every three months. If this happens, the bank should be able to locate any misappropriation or siphoning much earlier in the loan cycle.

As the system stands, there are some mechanisms in place to ensure loans are not wrongly utilised by companies. Every company must have an annual audit – called a statutory audit – of its accounts by an external accountant, for the purposes of reporting to the government, tax authorities and shareholders. Also, companies with an average turnover of over Rs 5 crore must have an independent internal audit to report to management. If there was a quarterly monitoring in addition to this, as suggested by our corporate default expert, there should be very few instances where wrongly-utilised or siphoned-off loans escape notice and morph into wilful defaults.

“If a bank and the auditors are surveilling an account, they cannot discover all of a sudden at the end of three-four years that money has been siphoned off or was used for different purposes,” said the corporate default expert. “So you cannot have a wilful defaulter without the banks and the auditors at the very least being, if not complicit, highly incompetent at their jobs.”

From lax lending standards by banks, shoddy loan monitoring and audits, an overly-indulgent RBI that looks the other way as banks fail to recognise bad loans, and the hodgepodge of laws and courts that make loan recovery extremely difficult, there are wide ranging and deep cracks in India’s credit framework. Almost 20% of loans — according to the RBI’s default list – are labelled as being in wilful default. That points to a systemic failure from end to end.

In a well functioning system, NPA’s should be cyclical. This means that bad loans should increase (marginally) during economic downturns and decrease (marginally) during periods of growth. Mismanagement of this issue at every level of the government, banks and the RBI has converted a cyclical issue to a structural one.