WILLFUL DEFAULT IN DEVELOPING COUNTRY BANKING SYSTEM: A THEORETICAL EXERCISE

Abstract

We construct a sequential game to highlight the incidence of 'willful default' in a developing country banking system where the borrowing unit underreports its true financial position and defaults willfully. Specifically, the paper deals with the implications of willful default for profitability and ultimate loan decision-making process of the banks. It shows that if limited liability condition holds and the conditions of willful default are satisfied, the bank will extend maximum possible amount of loan. However, it also follows that higher the loan capacity of the bank, the higher is the incidence of willful default. These would imply important policy lessons for the regulator. In fact, the regulator faces a trade-off between higher incidence of willful default and higher profitability of the bank. What we observe in reality depends on the objective of the regulator.Keywords: Commercial Banks, Loan Default, Bank RegulationJEL classification: G20, G21, G28(ProQuest: ... denotes formulae omitted.)1. INTRODUCTIONStandard debt contract specifies among other things, the borrower's promise to offer a repayment of loans constant over states, with the bank being allowed to seize the whole cash flow when the repayment cannot be guaranteed. Most of the debt contracts are characterized by asymmetric information between the lender and the borrower which is thought to be the key to the persistent problem of loan default and the resulting accumulation of NPAs in the balance sheet of banks. In the context of debt contract, it may arise, in general, for two reasons. First, it may arise because borrowers who take out loans from the lender usually have much better information than the lender about the potential risk and return associated with the investment project that the borrower plans to undertake. Second, if the actual cash flow generated from the investment project is the private information only of the borrower, then default may arise.The borrowing unit may default 'willfully' for several reasons such as deliberate non-payment of dues despite adequate cash flow, underreporting of cash flow, diversion of funds, siphoning off funds etc. Whatever be the reason, when willful default occurs, this highlights the fact that direct truth revelation does not work in equilibrium debt contract. The literature on costly state verification claims that this kind of moral hazard problem can be solved if the lender can commit to verify ex-post the borrowers' cash flow and/or if the agents can contractually agree on large penalties for those borrowers who strategically default on their debt. In particular, with infinite penalties, the first-best allocation may be achieved. Intuitively, very large penalties provide the right incentive for borrowers to report their financial situation truthfully to the creditor, even if the latter audits only with a very small probability. Consequently, the asymmetric information can be eliminated at a cost, which tends to zero as the audit probability becomes sufficiently small (Becker, 1968). Thus it is easy to prevent untruthful reporting in the auditing zone and, therefore, truthful reporting need not be rewarded. However, following the real life examples, most existing models consider an exogenous upper limit to the penalty that can be imposed to defaulters (see Townsend, 1979; Mookerjee and Png, 1989; Border and Sobel, 1987) or assume that there is limited liability on the part of the borrower (Gale and Hellwig, 1985). Townsend (1979) and Gale and Hellwig (1985) show that debt contract may be so designed that it satisfies the incentive compatibility constraints and the truth revelation of the borrower's cash flow is the dominant strategy and, therefore, standard debt contract appears to be the optimal contract from the efficiency perspective. In contrast, in our analysis of willful default, standard debt contract does not appear to be optimal contract and so, in equilibrium there exists a positive amount of willful default. …