Concerns about RBI's `Strategic Debt Restructuring Scheme'

Indian Express, 26 June 2015.

RBI has released a `Strategic Debt Restructuring Scheme' which is aimed at improving the working of banks faced with defaulters. The legal foundations of this scheme are questionable. There are concerns about the economic thinking embedded in the scheme. India has a serious problem with how we handle defaulters. But strengthening India's bankruptcy process is about Parliamentary law on companies, and not the subject of banking regulation.

A large number of borrowers in India are in a state of default to their lenders, such as banks. At present, the machinery which kicks in, upon default, is a messy one. It destroy value on a large scale. The fear of messy default has restricted lending to only low risk companies, and thus harmed access to debt.

A third of the corporate sector is facing significant balance sheet distress, and this is feeding back difficulties to their lenders. Some banks may be sending good money after bad, giving more loans to distressed companies to make it look like things are fine. This reduces credit available to healthy companies. Many banks are lending less, out of fear about their solvency. This also reduces credit available to healthy companies.

A vicious cycle may be coming about. When banks pull back from lending, this hurts the macroeconomic situation, and when the macroeconomic situation worsens, this hurts asset quality in banks. In the overall picture of economic reform, solving this problem is an important one. While the bankruptcy process is a part of company law, the Companies Act, 2013, did not solve the problem. New work is required in order to establish a sound bankruptcy process.

RBI's `Strategic Debt Restructuring Scheme' is about the terms that banks can (must?) write into the loan agreements, which will kick in at the time of default. There is a lack of clarity about its legal foundations. Unelected officials cannot make law; they can only write subordinate legislation (termed "regulations") when empowered to do so by Parliamentary law. The text released by RBI does not show how RBI has come to have such powers. It is not clear that RBI needs to instruct banks how to write contracts. RBI has not followed due process in the drafting and release of this purportive "regulation".

When a firm defaults, money is generally owed to many people: other firms, banks, other financial firms, bond holders, etc. The bankruptcy process has to take a full view of the creditors, and establish protocols for the negotiation. Anything done by a sectoral regulator (e.g. RBI) will be an incomplete and faulty solution to the problem, even if it were grounded in sound legal homework.

The Scheme writes down, in considerable detail, what must happen. As an example, the Scheme says that the Joint Lenders Forum must take 51% equity shares, it writes down the procedure to be adopted for valuation of the shares, it says that the conversion must be approved within 90 days, etc. This is a bureaucrat's view of bankruptcy.

If only bankruptcy were so simple. When a firm defaults, there is no fixed recipe of what must come next. Perhaps the lenders should take shares and run the firm. Perhaps existing shareholders should pay off the lenders and extinguish the debt. Perhaps a third party might come along who takes control of the company. The exact percentages and prices cannot be predetermined. The most important element of the bankruptcy process is a negotiation which takes place, between the creditors, through which the next steps are planned. This negotiation is about business judgment. There should be no role for the legislature, the executive or the judiciary in determining the right answer. RBI's Scheme micro-manages the steps after default, and replacing subtle business judgment by a fixed bureaucratic scheme. This is bad economics.

RBI's mandate is to ensure banks are safe and sound. Their forays into the bankruptcy process in the past have given weak outcomes. As an example, RBI wrote regulations for ARCs through which banks have given out bad assets in exchange for paper which is overvalued through RBI regulations. In another example, RBI established CDR, which turned into a mechanism for banks to postpone bad news. The new Scheme will perhaps give a new class of opportunities where banks will be left holding 51% of the shares of unlisted companies in exchange for loans which are not repaid. More caution in banking regulation is required.

The Scheme is thus a disappointing combination of poor legal process that is grounded in weak economics. While India badly needs reform of the bankruptcy process, this is not a problem which lies in RBI's mandate or expertise.

Only Parliamentary law can cut through the problems of the bankruptcy process in India, and create a sound framework through which all creditors (not just banks) negotiate after a default. The government has appointed the `Bankruptcy Legislative Reforms Committee' (BLRC), led by T. K. Viswanathan. This Committee is to draft an `Indian Bankruptcy Code' which would be a clean and modern answer, grounded in good economics, for what the bankruptcy process should be. This is one of the most important initiatives of the government.

A key problem of the present environment is the presence of multiple frameworks such as DRT, CDR, JLF, etc. This creates forum shopping and increases delays. The bankruptcy process has become drawn out and involves battling it out through many steps. RBI's `Scheme' adds one more layer of complexity into a complex system. The Code needs to be a clean and modern replacement for these multiple procedures.

Parliamentary law on companies is not RBI's work. RBI's job is to achieve safe and sound banks. Why did banks give out so many loans that went bad? How are banks hiding bad news, by holding assets on their books at a value which is much higher than the market value of the assets? RBI's leadership should be asking questions about failures of regulation and supervision through which India is once again staring at a banking crisis.

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