March 10, 2008
Abstract: Although the recently announced waiver of farm loans was politically motivated, the government has argued that the waiver would give banks an opportunity to clean up their balance sheets. Regardless of the validity of this view, the real concern for the banking system is the disastrous long-term impact of the moral hazard that the waiver would entail, as the farmers who maintain credit discipline would now be induced to believe that defaulting is entirely rational.
Given that the waiver is now a fait accompli, three categories of mitigating measures have been discussed, namely: (a) Designing incentives like lower interest rates for borrowers with good track records; (b) Creating insurance against various risks present in any agricultural environment; and (c) Facilitating “debt swap” by setting up a “moneylender debt redemption fund”. Through these measures, the government can channelize the political dividend from the waiver into significant reforms in agriculture.
Keywords: loan waiver; budget; moral hazard; banking system’s finances; political; risk mitigation; incentives; collateral; scorched earth; Radhakrishna Committee; insurance; debt swap