By Neeti Shikha and Emily Reeve (University of the West of England)
India’s personal insolvency framework is at a crossroads. As household debt climbs, digital lending proliferates, and economic shocks from job losses to rising living costs push more individuals into financial distress, policymakers must ask: how should the law respond when people fall behind?
So far, both in India and in countries like the UK, financial systems have been built around the assumption that individuals behave rationally. This assumption extends also to over indebtedness when it is assumed that when overwhelmed by debt, individuals will calmly compare options, weigh the costs and benefits of bankruptcy versus informal settlements, and choose the most efficient route to recovery.
But this assumption simply does not reflect reality. Financial distress impairs cognitive function. Scarcity of money creates a scarcity of attention. When a debtor is worrying about how to pay rent or avoid harassment by creditors, they are not equipped to engage with dense legal forms or make careful long-term decisions. In addition, they may simply not have the knowledge to know where to go for help. Behavioural economics has consistently shown that under stress, people fall back on cognitive shortcuts, avoid complexity, and seek immediate relief often at the cost of long-term stability.
The insights of behavioural economists like Daniel Kahneman, Richard Thaler, Sendhil Mullainathan and Eldar Shafir help us understand why many debtors delay seeking help or end up choosing the wrong insolvency solution. People facing financial stress often suffer from what psychologists call present bias, the tendency to prioritise short-term needs over long-term consequences. This bias explains why borrowers may take high-cost credit to stave off urgent problems; despite knowing it will make their situation worse in the long run.
Another common behavioural trap is anchoring. Debtors often latch onto the first option presented to them, frequently by private advisers or advertising that push expensive solutions. In the UK, many individuals struggling with debt are steered towards Individual Voluntary Arrangements (“IVAs”), a formal, binding agreement to repay part of what they owe over a fixed period, regardless of whether this is the most suitable option for their situation. This reflects a common behavioural bias known as anchoring, where people tend to stick with the first solution presented to them, especially under stress. In the Indian context, it is similar to a distressed borrower being pushed into a One-Time Settlement (“OTS”) with a bank, without being made fully aware of alternative options such as loan restructuring, repayment moratoriums, or potential relief under the Insolvency and Bankruptcy Code (“IBC”). Once a particular solution is suggested, especially by a figure of authority like a lender or advisor, or a trusted friend or relative, it tends to become the mental default. The anchoring effect therefore discourages borrowers from seeking out potentially better-tailored remedies.
There is also status quo bias and decision inertia. Even when help is available, individuals may fail to act simply because the process feels too complicated or intimidating. In the UK, for instance, a legally available “breathing space” scheme allows for a 60-day pause in creditor action, but uptake is low because the burden is on the debtor to apply, often while navigating a crisis.
In India, where the formal rollout of personal insolvency law under Part III of the IBC is still in early stages, these behavioural realities are even more acute. Many Indians rely on informal or app-based credit, have little access to trustworthy advice, and operate under immense stigma when it comes to admitting financial failure. A system that expects them to proactively initiate complex legal proceedings, without addressing cognitive and emotional barriers, is unlikely to succeed.
A Smarter, Human-Centric Approach
We believe that the solution lies in redesigning the system to work with human behaviour, not against it. Behavioural economics isn’t just theory, it provides practical tools that can be used to improve the design of legal and policy systems.
One of the most powerful tools is the use of defaults. Defaults work because most people tend to go with the pre-selected option, especially when overwhelmed. This insight has transformed pension savings in the UK, where automatic enrolment led to dramatic increases in participation. In the insolvency context, we propose a similar shift: rather than expecting debtors to apply for breathing space, creditors should be required to initiate it automatically once certain signs of distress such as 60 days of missed payments are evident. The debtor can still opt out, but the default would be early intervention, not crisis management.
Another critical intervention is to embed financial coaching into the insolvency process. Behavioural science shows that people in distress benefit more from guided, supportive advice than from technical legal explanations alone. A short, structured programme focused on budgeting, goal setting, and understanding debt consequences can significantly improve outcomes. In countries like the US and Australia, such coaching is already part of the bankruptcy process. India could adapt this model through local Debt Counselling Centres, ensuring that individuals are supported not just legally but psychologically.
We also propose a cooling-off period before individuals commit to long-term insolvency solutions such as one-time settlements or court-supervised restructuring. Research has shown that people under stress tend to agree to whatever is presented first, often without reading the fine print. A mandatory delay combined with behavioural prompts that encourage reflection could help prevent hasty, unsuitable decisions.
Stigma is another major barrier. Many people avoid seeking debt relief because of the shame associated with insolvency. This is particularly pronounced in India, where financial failure carries moral and social judgment, especially in tight-knit communities. While public records of insolvency may be necessary for transparency, and for potential creditors to assess risk, we believe they should be time-limited, anonymised after a few years, and accompanied by neutral language. A person who has followed a legal path to resolve debt should not continue to suffer reputational consequences years after discharge. In countries like Germany and Canada, records are automatically removed after a fixed period, balancing transparency with dignity. India can do the same.
India's Opportunity to Lead
India is in a rare position to design its individual insolvency framework from a clean slate. Unlike the UK, where reforms must retrofit an existing system, India can embed behavioural insights from the start. That means designing communication that is simple and jargon-free, introducing digital nudges like “Are you sure?” pop-ups for high-interest loans, and mandating standardised, visual disclosures of loan terms in absolute numbers not just APR percentages few understand.
It also means addressing the root causes of mis-selling and exploitation. Just as the UK has clamped down on commercial firms pushing IVAs for profit, India must ensure that any registered debt advisers are held to standards of impartiality and transparency, with strict penalties for predatory behaviour.
The Bigger Picture
Ultimately, personal insolvency law is not just about managing bad debts, it is about ensuring economic dignity and reintegration. It is about recognising that people make mistakes, or are hit by unforeseen life events, and that the law should support—not punish—them in getting back on their feet.
A system designed with behavioural insights can reach more people, prevent costly errors, and reduce stigma. It can also promote responsible lending, improve trust in financial institutions, and support broader goals of financial inclusion and resilience.
The question isn’t: why don’t debtors make better choices?
The real question is: how can the system make better choices easier by design?
