Setting up the ecosystem for personal credit

by Renuka Sane.

Why should we take interest in individual credit?

When we think of a credit market, we generally think of borrowing by large firms. But individuals, like you and me, are also important participants in credit markets. Some of us are entrepreneurs - we dream of new ventures, and in the process create new goods and services. As entrepreneurs, we often start out as sole proprietors, limited by the equity financing we can muster. In all countries, credit to individuals is a mechanism for small business financing.

In addition, borrowing is done by individuals in order to shift consumption through time. This is called consumption smoothing. This is especially important for low-income households whose incomes are reliant on seasonal cycles such as agricultural harvest, but whose consumption patterns require liquidity over the entire year. Alternatively, when poor people are faced with shocks like illnesses, borrowing helps improve the stability of consumption.

In short, the objective of a well functioning market for personal credit is that it should support entrepreneurship by individuals and consumption smoothing.

The importance of credit for individuals is reflected in the emphasis that programs such as Startup America, and the Entrepreneurship 2020 Action Plan, EU are placing on accessing capital. The importance of credit is also seen in the growth of micro-finance in economies in South Asia and Latin America, which cater to the demand for credit from low-income consumers.

How well are we doing in India today?

Financial exclusion

The CMIE household survey data shows that only 14% of households had credit outstanding in March 2014. This highlights the failure of decades of policies that have attempted to obtain financial inclusion through heavy-handed State interventions. The lack of availability of adequate and timely credit is the biggest problem affecting the growth of the small scale enterprises in India (Banerjee and Duflo, 2014). Financially excluded households lack the ability to smooth consumption. This induces welfare loss. It also gives them extreme incentives to seek out informal credit at outlandish prices as the marginal utility of consumption smoothing is extremely high.

Concerns about consumer protection

Many loan products involve unfair terms that customers do not understand, or interest rates that are so shrouded, that customers are not able to rationally evaluate the expected repayments. There have been several complaints regarding such practices by banks as well as informal sector lenders. Such mis-selling makes consumers wary of transacting, and lays the political foundations for extreme government interference (Sane and Thomas, 2015).

Emphasis on secured credit

The bulk of personal loans outstanding are housing, vehicle, consumer durable and education loans - all of which are collateralised. The credit market in India only delivers capital to those who have assets to pledge. This is true of SME loans as well. This constrains entrepreneurship, especially in service, technology and knowledge industries which require a system that lends based on an assessment of future cash-flows, and not on the basis of existing collateral.

Lack of sound arrangements when faced with default

All over the world, orderly systems have been setup to cope with consumer default. In India, some creditors have resorted to coercive collection practices. Incidents in the early 2000s led RBI to issue a circular on Guidelines on Fair Practices Code for Lenders, May 2003 that directed lenders to not resort to undue harassment for loan recovery. Anecdotes suggest that the practice is not fully controlled. The micro-finance crisis in Andhra Pradesh in 2010 also had its roots in coercive collection practices. Even if strong arm tactics are not used, a person with unpaid loans has no way of cleaning the slate and starting over. Legal proceedings are known to linger on for decades.

Loan waiver programs

India has a long history of loan waiver programs. Sensational stories about poor people burdened under large amounts of debt from evil lenders gain traction in the political discourse. The largest of these was a Rs.760 billion farm debt waiver in 2008. The adverse effects of such a waiver include the destruction of the loan repayment culture and a rise in strategic defaults. For example, Gine and Kanz (2014) find that moral hazard in loan repayment intensified after the 2008 program. The threat of future loan waiver programs by the government makes banks complacent and reduces the credit culture among borrowers.

Diagnosing the problem

The first problem in the personal credit ecosystem is the lack of consumer protection that can safeguard against mis-selling at the time of the sale of the loan, coercive recovery practices, etc.

The second problem is the absence of well-functioning insolvency framework for enforcing repayment of loans. It is the job of insolvency laws to ensure that creditors can seek remedy of the courts to force the debtor to restructure the loan, or to liquidate assets to pay off the creditors. The presence of such laws, and smooth institutional mechanisms which enforce these laws, makes creditors more willing to lend. The laws also ensure that debtors can also seek remedy from immediate collection actions of creditors, and buy time to reorganise their finances, or sell assets, at the end of which they can get a "fresh start". This makes them open to taking more risks. The design of institutions in personal bankruptcy shapes the functioning of credit markets (White, 2005). This is why, for example, bankruptcy procedures and a second chance for honest entrepreneurs is core to the Entrepreneurship 2020 Action Plan in the EU described earlier.

The way forward

Building a sound market for individual credit requires a two-pronged approach. One part is enacting the draft Indian Financial Code, which sets up a sound regulatory framework for financial firms and ensures consumer protection. The second part is the draft Insolvency and Bankruptcy Code, which sets up the machinery for dealing with default.

The draft Insolvency and Bankruptcy Code has four core features:

• It proposes an Insolvency Resolution Process (IRP) in which creditors and debtors can re-negotiate the repayment of loans. This offers debtors relief from collection action of creditors, while offering creditors a chance to collect their dues over time. This would be particularly important for personal insolvency which is really the insolvency of a proprietership.
• The Bill also proposes a bankruptcy process in case the negotiations fail - this implies the sale of personal assets to repay creditors.
• For low-income households with small loans, the Bill proposes a Fresh Start mechanism, whereby a debtor can seek to waive off his debts. This brings an element of predictability in the way loan-waivers take place in the country, distributing them through time as a large number of small transactions, and shifting the burden from the taxpayer to the shareholders of banks. Moral hazard is contained by flagging the person as a defaulter, for life, through credit bureaus.
• No matter what trajectory is followed, the set of steps that are followed after default by a person are specified clearly, these steps play out in modest periods of time, and end with the case being disposed of. This is in contrast with the present arrangements where a default turns into a legal problem for decades.

The draft Bill thus balances two objectives: on one hand, it provides debtors some relief through the discharge of some of their debt, and on the other, it seeks to improve credit availability by enforcing repayment.

Rolling out the consumer protection framework proposed in the IFC and the individual insolvency framework proposed in the IBC will lay the foundations for a healthy market for individual credit.

References

Banerjee and Duflo (2014), Do Firms Want to Borrow More? Testing Credit Constraints Using a Directed Lending Program, Review of Economic Studies, 81(2): 572-607

Gine, Xavier and Kanz, Martin (2014), The Economic Effects of a Borrower Bailout: Evidence from an Emerging Market, World Bank Policy Research Working Paper No. 7109.

Sane, Renuka and Thomas, Susan (2015, forthcoming), "The real cost of credit constraints: Evidence from micro-finance", The B.E. Journal of Economic Analysis and Policy.

White (2005), Economic Analysis of Corporate and Personal Bankruptcy Law, NBER working paper 11536, July 2005. Published as "Bankruptcy Law," in Handbook of Law and Economics, edited by A.M. Polinsky and Steven Shavell. Elsevier.

There will be no pigeon singularity

Pigeons were trained to behave like skilled doctors. When a computer is trained to behave like a skilled doctor, we think this is quite portentous. But when a pigeon does this, we never fret about the coming pigeon singularity.

The computational hardware in the pigeon's head is some bunch of neurons. Using rewards and punishment, we are training this neural network. Training neural networks gives the ability to do specific tasks. However, no amount of hardware for special purpose tasks (pigeons or dogs or Watson) closes the gap which separates the machine learning revolution from general intelligence, creativity and consciousness. It is genuine progress in engineering when dogs can smell abnormal blood sugar or when computers can drive cars. These do not, however, add up to strong AI.

Bankruptcy reforms: It's not the ranking that matters

by Rajeswari Sengupta.

India lacks a single, comprehensive law that addresses all aspects of insolvency of an enterprise. The current system of corporate insolvency resolution is characterised by a fragmented legal framework, and weak institutions. The absence of a well-functioning resolution mechanism results in poor outcomes in terms of timeliness of resolution, recovery rate, as well as costs associated with insolvency proceedings. These problems have also contributed to the ongoing balance sheet crisis of banks and their borrowers. In response to these problems, in 2014, the Ministry of Finance set up the `Bankruptcy Legislative Reforms Committee' (BLRC), to recommend a consolidated insolvency and bankruptcy resolution code that would be applicable to all non-financial enterprises and would replace existing laws and resolution guidelines. The report and draft bill of BLRC were released on 4 November 2015.

In recent times, the Indian government has taken great interest in addressing the problems of doing business in India and improving India's rank in the World Bank's `Doing Business' report. One of the parameters evaluated in this report is `Resolving Insolvency'. India's current rank in the ease of `Resolving Insolvency' is 136 in the world, which is roughly the same as the overall rank for India, which is 130. Reform of the corporate insolvency resolution framework is therefore an important element in the overall agenda of improving India's ease of doing business ranking.

In this article we ask the question: What would the legislative reform proposed by the BLRC do, for India's score in `Resolving Insolvency' in the `Doing Business' rankings?

The draft bill lays out a formal resolution process that is a significant improvement on the procedures currently in place. It provides for collective making decision by creditors, aims to lower information asymmetry in decisions through the use of information utilities, gives the right to initiate insolvency proceedings to both debtor and creditors, clarifies the role of the adjudicating authority, facilitates the conduct of insolvency proceedings by professionals, creates a calm period when a moratorium is imposed and negotiations can take place, specifies well defined penalties for fraud, and provides for a linear flow of events from viability assessment to resolution. In terms of the insolvency resolution process, the proposed law looks good on paper. If enacted, it will result in the ancillary benefit of improving India's score in the `Resolving Insolvency' parameter in the `Doing Business' report.

It is important to emphasise  that the World Bank's `Doing Business' rankings reflect a de jure approach of evaluating what should happen under the stated law, as opposed to what does happen in practice. If a bill, which meets certain criteria, is enacted, the ranking of a country in ease of `Resolving Insolvency' will improve even if the working of the insolvency resolution process, on the ground, diverges from what is intended in the law.

Impact of BLRC proposals on India's `Strength of Insolvency Framework Index' score

The overall `Resolving Insolvency' parameter consists of two indicators: `recovery rate' and `strength of insolvency framework index'. In this article, we focus on the second: the `strength of insolvency framework index'. This indicator analyses the strength of the legal framework applicable to insolvency proceedings and tests whether a country has adopted internationally recognised good practices in the area of insolvency resolution. We analyse the change that could come about for India's score in this indicator if the draft bill is passed by the Parliament.

The `strength of insolvency framework index' is the sum of four component indices. Each component index in turn consists of multiple sub-components, ranked on a scale of 0-1. The overall `strength of insolvency framework index' is measured on a scale of 0-16, with cumulative scores across 16 sub-components.

Indicator	Present scenario (DB 2016)	Under the new bill
Strength of insolvency framework (0-16)	6.0	12.0
A. Commencement of proceedings (0-3)	2.0	2.5
Procedures available to debtor	Liquidation only (0.5)	Reorganisation & Liquidation (1.0)
Creditor filing for debtor's insolvency	Yes, Liquidation only (0.5)	Yes, Reorganisation Only (0.5)
Basis for insolvency commencement	Inability to pay debts (1.0)	Inability to pay debts (1.0)
B. Management of debtor's assets (0-6)	3.0	5.5
Continuation of contracts supplying essential goods & services	No (0.0)	Yes (1.0)
Debtor's rejection of overly burdensome contracts	Yes (1.0)	Yes (1.0)
Avoidance of preferential transactions	Yes (1.0)	Yes (1.0)
Avoidance of undervalued transactions	Yes (1.0)	Yes (1.0)
Debtor obtaining credit post commencement	No (0.0)	Yes (1.0)
Priority to post commencement credit	No (0.0)	Yes, over all creditors (0.5)
C. Reorganisation proceedings (0-3)	0.0	1.0
Creditors voting on proposed reorganisation plan	No (0.0)	Yes (1.0)
Dissenting creditors receive at least as much as in liquidation	No (0.0)	No (0.0)
Creditor class-based voting & equal treatment	No (0.0)	No (0.0)
D. Creditor participation (0-4)	1.0	3.0
Creditor approval for selection/appointment of IP	No (0.0)	Yes (1.0)
Creditor approval for sale of debtor's assets	No (0.0)	Yes (1.0)
Creditor right to request information from insolvency representative	No (0.0)	No (0.0)
Creditor right to object to decisions accepting/rejecting claims	No (0.0)	Yes (1.0)

By this calculation, the enactment of the draft insolvency bill would improve India's `strength of insolvency framework' index from 6.0 to 12.0. This would place India ahead of developed economies such as Canada, France, Hong Kong, New Zealand, Netherlands, Norway, Singapore, and United Kingdom; emerging economies such as China, Colombia, Indonesia, Malaysia, Mexico, Peru, Russia, Thailand, Turkey, and Vietnam, and at par with Australia, and Sweden.

Similar analysis is required for the other element, the `recovery rate', so as to fully assess how the present proposals for bankruptcy reform would change the overall `Resolving Insolvency' score for India in the `Doing Business' rankings.

Limitations of this thinking

Many times, in economic measurement, we are able to observe the de jure status, but what really matters is the de facto outcome. This distinction is an important one when using the World Bank's `Doing Business' scoring.

On a de jure basis, the draft bill will improve India's score in the ease of `Resolving Insolvency' parameter, and there may be some merit in this as a first step. However, while we would like to have an improved `Doing Business' score, we in India should primarily focus on de facto outcomes about recovery rates, and not be satisfied with de jure improvements alone. If the latter were the sole objective, cosmetic changes to the Companies Act 2013 is all that is required.

In a recent paper, Hallward-Driemeier and Pritchett, 2015 show that there is practically no correlation between the findings recorded in the `Doing Business' report and the ground realities of doing business. This derives from the large gaps that often exist between laws and regulations on paper, and the manner in which these are enforced in reality, especially true of developing countries.

For instance, one of questions asked in the World Bank questionnaire is: Does the insolvency framework allow a creditor to file for insolvency of the debtor? While the answer to this would be `Yes' if the draft bill proposed by BLRC is enacted, in reality the filing process might be too cumbersome in the absence of good enabling infrastructure. This, in turn, would affect the timeliness of resolution and might also distort incentives for creditors to trigger insolvency proceedings to begin with. But these issues are ignored owing to the way in which the question is designed.

The BLRC report has emphasised the substantial scale of institution building, and State capacity construction, that is required in order for the insolvency and bankruptcy processes to work well. Effective implementation of the draft insolvency bill requires building four institutional pillars:

1. A private competitive industry of information utilities
   
2. A private competitive industry of insolvency professionals
   
3. Adjudication infrastructure
   
4. A well-functioning regulator
   

There are several concerns about the draft bill on these four areas. Much more work is required on these fronts, in terms of strengthening the draft bill and implementing it.

Focusing on improving India's ranking in the ease of doing business report is thus problematic. There is a danger of engaging in `isomorphic mimicry' where the reform process gains legitimacy by adopting `international best practices' in the drafting of the bill without actually obtain the desired outcome. We need to devote energy and resources to a full implementation plan that involves perfecting the law, creating good institutions and building adequate State capacity. The outcomes that matter are recovery rates, equal treatment of unsecured creditors, treatment of bond holders, etc. -- not the Doing Business ranking.

The new FDI policy: Well begun is not half done

by Bhargavi Zaveri and Radhika Pandey

A recent press release issued by the Central Government proposes to usher in 'radical' FDI-related reforms touching 15 major sectors of the economy. Key changes to the FDI framework include raising the limit for FDI approvals from the Foreign Investment Promotion Board (FIPB) to Rs 5,000 crore from Rs 3,000 crore, increasing foreign-investor limits in several sectors including private banks, defence and non-news entertainment media as well as allowing foreign investors to exit from construction development projects before completion.

The stated objective of these reforms is to "ease, rationalise and simplify the process of foreign investment" in the country. The reforms comprise of easing sectoral caps in some sectors, moving some sectors from the approval route to the automatic route and granting special dispensations to entities owned and controlled by NRIs. These measures could benefit certain sectors and augment FDI flows. Going forward, these measures may also propel our investment rankings. However, like most reforms to the capital controls framework of the post-1999 period, this purported reform also ignores the substantive issues of ad-hocism, executive discretion and the absence of rule of law that pervade the administration of capital controls. Unless we address these fundamental issues, incremental reforms of this nature will be of little help.

This post focuses on four such mistakes that the recent press release continues to make.

Distinguishing between investment vehicles

Principle: The capital controls framework should be agnostic to the channel through with foreign money is being routed. The relation between ownership and management which is the basis for distinction between a company and a Limited Liability Partnership should not be a concern for the capital controls framework.

Today, FEMA has different rules for treating foreign investment made in an Indian company, an Indian partnership firm, an Indian trust and an Indian LLP. For example, while non-residents are allowed to invest in an Indian company, only NRIs are allowed to invest in an Indian partnership firm on a non-repatriation basis. Foreign investment in a LLP is allowed only under the Government route. Moreover, to be eligible to accept FDI, the LLP must be operating in a sector where 100% FDI is allowed under the automatic route and where there are no FDI-linked performance conditions. Further, a LLP having foreign investment is not allowed to make downstream investment in India.
The press release proposes to allow FDI in a LLP under the automatic route. It also proposes to allow a LLP with FDI to make downstream investment in a sector in which 100% FDI is allowed under the automatic route and there are no FDI-linked performance conditions.

A liberalisation policy must be indifferent to the vehicle through which FDI comes into India. Whether FDI comes in through a company or a LLP, the same rules must apply. The reporting requirements may differ depending on the investee entity. So, for instance, for LLPs or trusts with FDI, the regulatory framework may prescribe more detailed reporting requirements, as compared to a company with FDI. Restrictions on capital flows must not driven by the nature of the investee entity.

By creating artificial restrictions which are driven by the nature of the investing entity, the FDI policy only adds to the complexity of investing in India. For example, take a situation where a foreigner is interested in investing in an advertising agency, a sector where 100% FDI is allowed under the automatic route. She makes the investment in a LLP engaged in advertising. Now, the advertising agency proposes to expand into another activity, say, print media which is under the Government route. Under the current policy, the LLP will not be able to expand its operations as print media is under the government route nor will it be able to incorporate another company, as under the proposed policy, downstream investment by a LLP with FDI is permitted only in sectors in which 100% FDI is allowed under the automatic route. However, this problem would not crop up if she invests in an Indian company engaged in advertising.

The press release allowing FDI in a LLP under the automatic route is, thus, a mere addition to the error of mandating different rules for FDI in different kinds of entities.

Special dispensations to NRIs

Principle: For the purpose of administering capital controls, the rules for foreign money should be similar whether it comes through an NRI owned and controlled company or through other overseas investor.

Currently, NRIs have certain benefits as compared to other non-residents when investing in India. The press release proposes to extend these benefits to entities owned and controlled by NRIs. There are two issues involved here. First, to address the concerns of money laundering and terrorist financing, the entities owned and controlled by NRIs should only be allowed through the FATF compliant jusridictions.

Second, this proposal tantamounts to revival of the concessions which were granted to Overseas Corporate Bodies (OCBs) under FEMA, which were eventually withdrawn in 2003. While the concerns relating to OCBs were largely related to ownership of OCBs accessing the Indian securities markets under the Portfolio route, OCBs were de-recognised as an investor class altogether. One of the concerns regarding OCBs was the ownership of these OCBs, and whether they were legit vehicles for investment by NRIs. Under the Consolidated FDI policy, a NRI is allowed to invest in the capital of a partnership or proprietorship in India on repatriation basis with the previous approval of RBI.

With the new framework in place, this benefit will be extended to entities owned and controlled by NRIs. It is unclear how the framework will be implemented to ensure that the shares of the foreign entities owned and controlled by NRIs are not transferred to non-residents who are not NRIs. If the NRIs want to sell their control, will the priveleges given to the companies owned and controlled by NRIs have to be withdrawn? How will the Government know if the company is still owned and controlled by NRIs. To avoid such complexities a rational solution would be to move to harmonise the capital controls framework for all kinds of non-resident investors--be it NRIs or foreign investors.

There is no economic reason for treating a certain class of non-residents and their investments differently from other non-residents. For example, this press release proposes to exempt NRIs from the 3-year lock-in period imposed on non-residents investing in the real estate sector. Presumably, the reason for imposing a 3-year lock in period for foreign investors is to ensure that they do not pre-maturely withdraw their capital from the project. There is no reason for not applying this line of reasoning to investments made by NRIs in this sector. Uniform treatment of all non-residents is more important to the ease of doing business in India, than favouring NRI investments.

Sectoral exemptions

Principle: Financial regulation including regulation of capital controls should be motivated by market failure. The capital controls framework should not be designed to protect Indian promoters. Contractual obligations between the investor and investee should not be forced through the capital controls framework. The rules should provide a level playing field for all investors.

A key highlight of the new FDI regime is that it allows foreign investors to exit before the completion of the project in the construction sector. This is a laudable step. At the same time, it imposes a lock-in period of three years calculated with reference to each tranche of foreign investment. This is undesirable. The terms and conditions on which a foreign investor may exit an Indian real estate business, must be purely contractual and based on commercial wisdom.

Further, certain sectors like Hotels and Tourist Resorts, Hospitals, Special Economic Zones (SEZs), Educational Institutions, Old Age Homes and investment by NRIs are proposed to be exempted from the condition of lock-in. It is difficult to decipher the principles guiding the decision for exempting certain sectors from the lock-in condition while imposing conditions on others. This creates problems of political economy. Sectors which are not given the lock-in exemption will be encouraged to lobby and persuade the authorities to add them to the list of exempted sectors. This may result in undesirable consequences including additional administrative workload without addressing any fundamental market failure.

Booklet of press releases and notifications relating to FDI

Principle: Capital controls must be administered through a legally enforceable instrument. The complex of maze of regulatory instruments should be replaced by one authoritarian position of law. The private sector then should be free to make many ``user friendly documents".

Capital controls is governed by the Foreign Exchange Management Act, 1999 (FEMA). The RBI has the authority to frame regulations under the Act. Capital controls is governed by foreign exchange management (FEM) regulations. Amendments to these regulations must be tabled by the RBI (as notifications) and approved by Parliament in order to be legally enforceable. The Department of Industrial Policy and Promotion (DIPP), Ministry of Commerce and Industry, makes policy pronouncements on FDI through Press Notes/Press Releases which are notified by the Reserve Bank of India as amendments to the Foreign Exchange Management (FEM) Regulations. The procedural instructions are issued by the Reserve Bank of India through A.P. (DIR Series) Circulars. The RBI also issues master circulars that act as a compendium of the notifications/circulars issued in the previous year, without necessarily covering all the details. The DIPP also issues a consolidated FDI policy that subsumes all Press Notes/Circulars that were in force. The regulatory framework thus consists of Act, Regulations, Circulars, Master Circulars, Press Notes, Press Releases and a Consolidated Policy on FDI.

The press release proposes to add another instrument to this list. It instructs the DIPP to consolidate all its instructions in a booklet so that investors do not have to refer to several documents of different frames. The practice of issuing binding instructions through `policy documents' is one of the most fundamental errors of our capital controls framework. No amount of consolidation or simplification can substitute this error.

Executive action which restricts the actions of private citizens must be taken only through a legally enforceable instrument. This is because a legally enforceable instrument has gone through the rigors of law making, will go through some accountability mechanism (such as tabling before Parliament in case of delegated legislation) and can be challenged in a court of law. `Policy decisions' go through none of these checks and balances. There is also the danger of easy reversal.

At present, the processes we follow for making the rules for entry and exit of foreign investors in India are largely driven by `policy actions'. First, sectoral caps, terms and conditions of foreign investment and its repatriation, are virtually "regulated" through a policy document which neither goes through the rigors of law making nor is subject to the accountability of delegated legislation, such as tabling before Parliament. Second, even if the policy is translated into a binding instrument (namely, regulations by RBI), the process of translation suffers from time-lags and inconsistencies.

Conclusion

Improving the ease of doing business in India requires more than sector-specific initiatives or making special dispensations. The problems run deep. They are ultimately grounded in the Foreign Exchange Management Act, 1999, and the subordinate legislation and institutional machinery which enforces it. Solving problems will require going to the root cause, as has been recommended by numerous expert committees.

The limits of grassroots empowerment

Citizens -> Government

Ever since Plato, we have known that direct democracy does not work well. When faced with a question like one-rank-one-pension, we will not get the right answer by asking the people. The mechanism that works better is to have a representative democracy, also termed a "republic", where the people elect representatives who write law. The recourse to referendums where the people vote is a bad way to organise things.

With modern technology, the transactions costs of voting are no longer a barrier. It's quite easy to conceive of mobile phones offering one or two resolutions on which the people vote, every day. However, the voice of the people is not a good way to run a country, as the people do not have knowledge of the machinery of government. The people should be involved at a deeper question of values and objectives. The people should elect representatives who will pursue objectives that the people like. The voice of citizens should shape the priorities of their representatives, but it is the representatives should get engaged with the wonkish details.

Shareholders -> Firms

The same three step process is found with firms. Shareholders are the ultimate beneficiaries of well run firms. But shareholders are seldom the right source of decisions about the management of firms. Shareholders should recruit a board of directors who would then be akin to the legislature of the firm.

With modern technology, the transactions costs of voting are no longer a barrier. It's quite easy to conceive of mobile phones offering one or two resolutions on which the shareholders vote, everey day. However, the choice of shareholders is not a good way to run a company, as shareholders do not have knowledge of the machinery of the firm.

Customers -> Firms

Josh Dzieza has an article in The Verge about customers rating employees of firms, and thereby working as supervisors of employees, which links to similar themes. The article has an element of outrage about micromanagement of employees, which I don't share. All management is about principal-agent problems, and if customers help improve monitoring of employees, in general, that's a good thing. (In equilibrium, more intrusive supervision may go with higher wages, if many employees dislike that level of monitoring).

But I think there is a deeper point here which is worth mulling about. Is putting customers in charge a bit like putting shareholders in charge or putting voters in charge? Customers may not always choose things that are best for organising production. Managers, and not customers, have the full picture of how production is organised. The best price / performance for customers may not come from giving too much power to customers.

Conclusion

Ubiquitous computer and telecom technology has made it possible to organise the world in ways that empower the grassroots. To many people, this is instantly attractive, as a way of breaking away from the hierarchical power structure of the pre-technological world. We are always sympathetic to voters or shareholders or consumers being empowered with mobile phones.

There are places where hyper-empowered citizens are a good thing. But this is not true in general. Most of the time, we will need management who take responsibility for organising things in ways that are good for voters, shareholders or consumers.

Inconsistencies and forum shopping in the Indian bankruptcy process

by Aparna Ravi.

The current legal framework for resolving bankruptcy in India is broken, and a committee created in 2014 has proposed a new legal framework to fix it. The effort to fix a broken law is not unusual by world standards. Most countries, even those with stable bankruptcy outcomes that earn them high rankings in the World Bank Doing Business report, appear to be continuously creating new statutes or amending existing ones. For a sense of perspective, the current UK bankruptcy framework was put in place in 2002. In the US, the 1978 Bankruptcy Reform Act was the single biggest change that established specialised bankruptcy courts. But this has been followed by changes in 1984, 1994 and 2005, indicating a decadal cycle of review and reforms.

What is unusual about the Indian reforms is that these reforms stemmed from a general discontent with the system, rather than specific tangible evidence on measured outcomes. This is a problem particularly for creating a new legal framework, because you would expect that such evidence is a prerequisite to guide the nature and the form of the required reforms. One analysis that was available to the Committee was a paper in the Journal of Corporate Law Studies by Kristen van Zweiten, 2015. The paper analyses an extensive set of high court judgments related to liquidation in India. The analysis of these judgements reveal judicial biases in the form of a pro-rehabilitation stance at the High Courts, which in turn, leads to a reluctance to liquidate a business that is judged unviable. The paper records that the bias has contributed to delays and ineffective resolution of corporate insolvencies in India.

However, liquidation is only one part of a bankruptcy framework. The bankruptcy resolution framework is typically made up of three parts:

1. Enforcement of debt by creditors, individually or as a group;
   
2. Collective assessment of whether the debt can be maintained through a financial rearrangement or entity reorganisation to keep the debt viable; and
   
3. Bankruptcy, where debt is liquidated if it is found to be unviable.
   

As in other parts of the world, the Indian framework has separate laws for each part. But unlike in other parts of the world, the Indian framework deviates in not having single law but, rather, is fragmented across multiple laws. More importantly, the different laws apply differently to different participants. For example:

1. Debt enforcement is available only to banks and selected financial institutions through the Recovery of Debt due to Financial Institutions (RDDBFI) Act, 1993, and Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002.
   
2. Collective action on enforcement are found in separate legislation depending upon the form of the debtor. For firms, it was first introduced in the Sick Industrial Companies Act, 1985 (SICA), and is now in the Companies Act, 2013. For partnerships, it resides in the Indian Partnership Act, 1932, and in the Presidency Towns Insolvency Act, 1909 and Provincial Insolvency Act, 1920 for individuals in the Presidency towns and for the rest of India.
   
3. Bankruptcy of organised enterprises are covered in the laws related to the enterprise. For example, a firm is covered by the provisions on winding up in the Companies Act, 1956 and 2013, while that of individuals is covered in the respective individual laws listed above. [1]
   

In a recent paper, An analysis of collective insolvency resolution and debt recovery proceedings in India, I extend the evidence about the failure of legal performance of firm insolvency and bankruptcy by analysing a broader set of judgements in insolvency and bankruptcy resolution. I analyse 45 judgments, heard between 2003 and 2014, that were selected to provide for a variety of different proceedings, and to involve different types and numbers of creditors and other stakeholders.

Even this relatively small sample is useful in identifying two themes that contribute to poor outcomes in insolvency and bankruptcy. The first theme is the pro-rehabilitation stance adopted in adjudication during liquidation, which is consistent with the finding in van Zweiten, 2015. The second theme identified are conflicts arising from having multiple laws and multiple fora for adjudication. One of the core objectives of a bankrutpcy process is to incentivise the debtor and creditors to negotiate towards an outcome that maximises economic value in insolvency. The paper finds that, in India, multiple laws that make up the bankruptcy framework incentivise creditors and debtors to act in their own best interests during this process.

Further, the analysis highlights the conflicts that arise from having the jurisdiction of these multiple laws resting with different adjudicating fora. For example, the High Courts are the adjudicating forum for the winding up process under the Companies Act 1956 and 2013, the BIFR the adjudicating forum under SICA 1985 and the civil courts the adjudicating for the individual insolvency acts. On the other hand, the adjudicator for the debt enforcement laws are the Debt Recovery Tribunals (DRTs) and Debt Recovery Appellate Tribunals (DRATs). This results in the process being diverted from swift resolution to one with extreme and frequent delays. Different laws being implemented across multiple jurisdictional fora is a key element that exacerbates the ability to delay the process of resolution.

Findings

The first outcome from the analysis is a measure of the delays in arriving at the final judgement. 17 of the 42 High Court judgments, for which data was available, took over 10 years for resolution (as measured from the date of commencement of the first action). 24 of the 42 took over 5 years. Seven of the 13 DRT/DRAT judgments took over 5 years for resolution. One of the causes for delays is the existence of multiple fora that the creditors and the debtor need to traverse to reach a resolution. In several of the cases reviewed, there was typically at least a few years of time lost between the BIFR providing a liquidation opinion and the High Court issuing a winding up order.

The conflicts that can arise from having fragmented laws and adjudicators is best illustrated with an example. One of the cases reviewed involved the following different actions [2]:

• Secured creditor 1 files an application in the DRT for debt recovery.
  
• Secured creditor 2 filed a company petition for winding up in the High Court.
  
• Secured creditor 3 entered into an MOU with creditor 1 to get paid upon recovery for creditor 1.
  
• A trade creditor that leased machinery to the debtor initiated proceedings invoking the arbitration clause in the contract.
  
• Secured creditor 4 initiated proceedings under the SARFAESI Act and sold assets by auction.
  
• Unsecured creditor 5 that had supplied a boiler to the debtor filed for debt recovery in the civil court.
  

While this may be at the extreme end of the spectrum, the majority of cases involved at least two or, more often, three parallel proceedings in different fora. In addition, the present law permits the process of winding up the firm and debt recovery from the same firm to run in parallel to each other. Particularly where the judiciary is fragmented across courts and tribunals, this leads to further confusion for creditors as well as debtors. Creditors remain uncertain of recovery even after proceedings have closed as it could always be challenged on the basis of another debt recovery or winding up action initiated on the same debtor. This is exacerbated by a pervasive lack of common information for cases against the same debtor. Often in the review, there were situations where one creditor initiates debt recovery unaware that similar actions have been initiated against the same debtor until much later in the process. Thus, the analysis demonstrates that the lack of a single, linear law compounded by the lack of common information leads to several instances of conflicts in using the law to resolve insolvency and bankruptcy.

When there is a lack of clarity in the law, the responsibility of resolving conflicts across these different laws and their interaction fall upon the High Court judge. Examples of some questions these judges had to grapple with are:

1. Can the debtors assets be sold pursuant to enforcement action under SARFAESI while a winding up petition is pending in the High Court?
   
2. Can a creditor initiate proceedings under the RDDBFI Act while SARFAESI enforcement action is ongoing?
   
3. Does the High Court have jurisdiction over debt recovery proceedings in the DRT once the winding up process has commenced?
   
4. If the Board for Industrial and Financial Reconstruction (BIFR) under SICA 1985 has referred a company for liquidation to the High Court, but the High Court is yet to pass winding up order, can a creditor bring an action for debt recovery in the meantime [3]?
   

Needless to say, the High Courts across the country interpret these conflicts differently. For example, on (a), the High Court of Telangana and Andhra Pradesh [4] held that the debtors assets could be sold in an auction pursuant to a SARFAESI enforcement action, while both the Madras and Karnataka High Courts ruled that the consent of the official liquidator was required for such a sale [5]. On (b), the DRT ruled that a creditor could initiate proceedings under SARFAESI while debt recovery proceedings under the RDDBFI Act were ongoing [6]. Nearly two years later, the Patna High Court held that the reverse did not apply and that proceedings under the RDDBFI Act could not be initiated if SARFAESI enforcement action had begun [7]. More than the letter of the law, how effective it is in implementation is shaped by the case law that emerges from its practice on the ground. Such conflicts in case law causes confusion in the resolution of similar future cases, further compounding the lack of certainty in the resolution of insolvency and bankruptcy of firms.

The final observation from case analysis worth touching on is that despite the law enabling debt enforcement even without the requirement of a court order (as is enabled in SARFAESI), this does not always work in practice. Debtors have the ability to challenge the enforcement of SARFAESI actions in the DRT. When this occurs, courts and tribunals often misinterpret the extent of their jurisdiction under Act. Under Section 17(2) and (3) of the SARFAESI Act, the role of the DRT or court when considering a challenge to enforcement action is to examine whether the secured creditors action was taken in accordance with the provisions of the SARFAESI Act and related rules. In practice, however, the DRTs and DRATs often overstepped this line to go on to adjudicate the substance of the claim itself. One such example is the question of how to determine the amount owed, or to impose or change conditions imposed by the creditor such as the amount of a deposit. It is, of course, difficult to ascertain the proportion of cases in which SARFAESI enforcement has been allowed to go unchallenged as opposed to those occasions on which it has been challenged in court. However, it appears that in cases where a debtor does challenge SARFAESI enforcement, creditors have experienced long drawn out struggles in the courts.

Implications for bankruptcy law reform

The UNCITRAL Legislative Guide on Insolvency, for example, states nine broad objectives of an insolvency law regime all of which also rest on having a collective mechanism for insolvency resolution:

1. Provision of certainty in the market to promote efficiency and growth;
   
2. Maximization of value of assets;
   
3. Striking a balance between liquidation and reorganization;
   
4. Ensuring equitable treatment of similarly situated creditors;
   
5. Provision of timely, efficient and impartial resolution of insolvency;
   
6. Preservation of the insolvency estate to allow equitable distribution to creditors;
   
7. Ensuring a transparent and predictable insolvency law that contains incentives for gathering and dispensing information;
   
8. Recognition of existing creditor rights and establishment of clear rules for ranking priority of claims; and
   
9. the establishment of a framework for cross-border insolvency.
   

The review presented in Ravi, 2015 identifies three observations about the bankruptcy process in India that stand against these UNCITRAL principles of a sound bankruptcy process:

• A legal framework fragmented across separate rights of debtors and creditors in collective action and debt recovery, as well as across different adjudicating fora.
  
• Lack of clarity in rights of the creditors despite strong debt enforcement laws.
  
• Delays in reaching final judgement.
  
• Delays in implementing bankruptcy.
  

The analysis points out that the fragmentation of the laws and adjudication fora has been a dominant factor in leading to poor bankruptcy outcomes, such as delays in resolution. Thus, a key requirement in the reforms of the legal framework for bankruptcy is to have a unified law. Such a law ideally ought to cover all aspects of a debtor in distress as well as apply to all stakeholders. While simply piecing together the multi-layered framework will not make all the problems go away, such a move would greatly help with the efficiency and predictability of the process, two important indicators for the success of any insolvency law regime.

A single law will also have the benefit of a single adjudicating authority to hear all cases of insolvency and bankrutpcy. One outcome of this will be to have a single adjudicating authority for all matters related to insolvency and bankruptcy, which will eliminate the incentives of debtors and creditors to undertake forum shopping to resolve insolvency.

Another critical component of change is to counter judicial innovations that have contributed to the delays in insolvency resolution. A new bankruptcy process should stipulate clear timelines for different processes, make it difficult (or close to impossible) to reverse winding up orders and provide sufficient guidance to limit the exercise of unfettered discretion by the single adjudicating authority.
Finally, it is important to consider the interaction between collective insolvency proceedings and debt recovery mechanisms. The purpose of insolvency law has often been described as providing sufficient incentives for creditors to favour collective insolvency proceedings over individualised debt enforcement actions. In India, however, most reforms in recent years such as SARFAESI have focused on providing mechanisms for secured creditors to recover through individual enforcement action. These initiatives are understandable and necessary in light of delays in court proceedings and the significant abuse of SICA by debtors who used the pretext of a stay to impede recovery by creditors. Yet, while banks and secured creditors may have had some success with SARFAESI (the extent of this success is itself questionable), this focus has come at the cost of an organized insolvency process that preserves value and benefits all stakeholders. A new unified bankruptcy code is an opportunity to reverse this trend by providing a linear and time bound mechanism for collective insolvency rather than debt recovery.

Footnotes

[1] The new Companies Act 2013 includes new provisions that deal with rescue and rehabilitation (Chapter IXX) and liquidation (Chapter XX). However, these provisions have not yet been notified.

[2] This example is based on the fact pattern in BHEL v. Arunachalam Sugar Mills Ltd., (O.S.A. Nos. 58, 59, 63, 64 and 81 of 2011, decided On: 12.04.2011), but similar parallel proceedings were found in a large majority of the cases reviewed.

[3] Sri Bireswar Das Mohapatra and Anr. V. State Bank of India, W.P. (C) No. 8567 of 2006. Decided On: 17.08.2006.

[4] Indian Bank v. Sub-Registrar, Writ Appeal Nos. 1420 and 1424 of 2013 and O.S.A Nos. 34 and 35 of 2013, decided on 11.11.2014.

[5] BHEL v. Arunachalam Sugar Mills Ltd., O.S.A. Nos. 58, 59, 63, 64 and 81 of 2011 Decided On: 12.04.2011; Kritika Rubber Industries v. Canara Bank, C .A. No. 190/2008 in Co. P. No. 167/1999. Decided On: 13.06.2013.

[6] Bank of India v. Ajay Finsec Pvt Ltd and Ors (OA No. 167 of 2001, decided on 28.11.2003).

[7] M/S Punea Cold Storage v. State Bank of India (AIR 2013 Part I; II (2013) BC 501 Patna HC).

A blueprint for overcoming systemic risk

by Avinash Persaud.

It is a testament to the need of getting financial regulation right, that almost ten years since the emergence of a crisis in sub-prime mortgages in the US, those countries most affected by the unfolding credit crunch are still struggling to put it behind them. Yet, recent announcements over the amount of capital banks are required to hold against risky assets and what constitutes capital reveals that the fundamental flaws that plagued the last approach to regulation remain. The Financial Stability Board, created by the G20 nations, announced on November 9, 2015, that the most systemically important lenders must have a total loss absorbing capacity, including bail-in securities, equivalent to at least 16% of risk-weighted assets in 2019, rising to 18% in 2022. Financial regulation has yet to find its compass.

Too many financial supervisors consider regulation to be an exercise in “de-risking”. They seek to curb risk by requiring banks to put up biting amounts of capital against risks. However risk shares much with the first law of thermodynamics: energy can neither be created or destroyed, just transformed. When we effectively tax risk in one place it shifts to where it is un-taxed, like shadow banks. When we find it there and tax it again, it merely shifts once more, perhaps to non-financial institutions and so on. The logical extension of this approach is that risk will keep on shifting until it ends up where we can no longer see it. That is not a good place for risks to be. The exercise should instead be about incentivising risk to flow out of dark corners, to where it is best absorbed.

Another fundamental flaw is the notion of risk-sensitivity on which the recently announced capital requirements are built. This idea suffers from the post hoc ergo propter hoc fallacy. Banks don’t topple over from doing things they know are risky; but from doing things they were convinced were safe before they turned risky. Against loans they think are risky, banks demand extra guarantees, collateral, interest and repayment reserves. Against their reported risk-weighted assets, they were never as well capitalised as just before the crisis. Its not the things you know are dangerous that kill you. And under the risk-sensitive approach they had the least capital against those assets the models thought were safe before they turned bad.

If that was not bad enough, in their practice of risk-sensitivity, banks, corralled into using the same risk models and data sets, ended up buying the same assets that the models calculated had the best yield to safety ratio in the past. They were then forced to exit these crowded trades at the same time when there was a disturbance in volatilities and correlations. What has been generously called the Persaud Paradox of market-sensitive risk management – the observation of safety creates risks – reveals the common fallacy of composition of regulation: Trying to rid individual financial institutions of risk does not make the financial system safe.

A further fundamental error is the treatment of different risks as if they can be added up together and the aggregate amount of risk hedged with capital independently of how it is made up. The inconvenient reality is that different types of risk require different hedges and capital is not always the best hedge. Moreover, the right hedge for one risk may make another risk greater. For instance, the way to hedge liquidity risk (which is the risk that were you forced to sell an asset tomorrow it would fetch a far lower price than if you could wait to find an interested buyer) is by having long-term funding to tide you over. If markets became illiquid and you were short-term funded, no tolerable amount of capital would save you. Credit risks, on the other hand (the risk that someone defaults on payments to you) rise the more time you have. Matching credit risk to long-term funding would increase credit risks. The way to hedge credit risks is diversify across assets, not time, and have capital to make up the possible short-fall.

The solution to these three fundamental flaws to the current approach to regulation is presented in my recently published book: Reinventing Financial Regulation. The key mechanism of any solution is incentives. Although many see bad and unethical behaviour in the crisis, most of the behaviour that contributed to the crisis was incentivised and would have taken place anyway because of these incentives. Banks sold credit risks to institutions that had no capacity to hedge or absorb credit risks, because they had to put up capital against credit risks and the special purpose vehicles, insurance firms and hedge funds that bought them did not. In place of the credit risks that banks could have diversified across their customers, banks bought illiquid instruments that they could not so easily hedge when markets froze, like long-term mortgages, loans to private equity investments and indecipherable combinations of credit instruments. They did so because illiquid assets had higher yields but regulatory capital was driven off the credit rating. Locking up bankers is a satisfying rallying call but will not work to moderate the booms that lead to the busts if we do not also address the incentives.

Financial institutions should be required to put up capital or reserves against the mismatch between each type of risk they hold and their innate capacity to hold that risk. Risk capacity is not risk appetite. It is not determined by your ability to measure the economic cycle, which collectively we have proven to be bad at, but the ability to naturally hedge a risk. Risk-sensitivity needs to move over for risk capacity. Institutions with long-term funding or liabilities like life insurers or pension funds would likely end up not having to put up capital for liquidity mis-matches but against the lack of diversity of their credit risks. Banks with their short-term funding would probably have to put up a lot of capital against maturity mismatches, but little additional capital if their credit risks were well diversified.

The consequence would be that banks would be incentivised to sell good-quality credit but low-liquidity assets, like infrastructure bonds, to insurance companies and buy in liquid but low-quality credit risks, like corporate bonds, that they could hedge better than others. We would get risk transfers that strengthened the financial system, the exact opposite of those we had in the run up to the financial crisis when risks ended up where there was least capacity to hold them, amplifying the inevitable crisis. The economy as a whole would be able to take more risks, more safely. This would not require onerous levels of capital or bond investors that are somehow supposed to be better at gauging risks than bankers, because risks would be where they could be absorbed and where if they blew up, they would not take down the entire financial system.

BLRC hands over the draft Insolvency and Bankruptcy Bill

The Bankruptcy Legislative Reforms Committee has submitted its report and has signed off on the draft Insolvency and Bankruptcy Bill. Today, the Ministry of Finance has released the report on Rationale and Design and the draft bill on its website.

How to build a sensible tax system

I have a column in the Indian Express today on this.