Building a better credit market

by Bhargavi Zaveri and Radhika Pandey.

In a previous article, Ashish Aggarwal has presented the big picture of where Budget 2016 fits into the overall journey of India's financial sector reforms. In this article, we take a more careful look at the initiatives on the credit market.

India faces a substantial balance sheet crisis. Roughly one-third of the corporate balance sheet and roughly two-thirds of the banking balance sheet is under stress. This has motivated an increased focus by policy makers on reforms in this field. There is an increasing recognition that the regulatory interventions by RBI such as Corporate Debt Restructuring, Strategic Debt Restructuring (SDR), Joint Lenders Forum (JLF), wilful defaulters, etc. have not delivered. There is talk about a publicly funded Asset Management Company, which also has many problems and is best not done.

What is needed in India is to look beyond banking and establish sound institutional procedures for the credit market. The Budget Speech in 2016 is a step forward in that it promises some structural reforms which go beyond the limitations of banking regulation to the bigger question of the working of the credit market.

Bankruptcy Code

The Bankruptcy Code replaces the currently fragmented Indian legal framework for the re-organisation and liquidation of firms and bankruptcy of individuals. However, there are two popular misconceptions regarding the Code.

First, the popular discourse often links the Code to resolving the impending NPA crisis on the balance sheets of Indian banks. The Code will not, in and of itself, resolve the NPA crisis faced by Indian banks today. The cause of the crisis is not a bad bankrutpcy regime (which may well contribute to the way the crisis unfolds), but mistakes in banking regulation and enforcement. The Code essentially does three things (a) codifies a process for allowing a debtor's finances to be reorganised by mutual negotiation before she is pushed to liquidation; (b) establishes institutional infrastructure by providing for a bankruptcy regulator and vesting insolvency jurisdiction in the NLCT and the DRT; and (c) creates a framework for an industry of insolvency professionals (professionals having expertise to administer the debtor's estate) and information utilities (repository-like infrastructure which will store information of debts and defaults).

Second, there is a misconception that the Code will, upon enactment, completely fix the insolvency regime in India. There are two problems with this perception:

1. The Code, in its current form, requires several improvements. In particular, it is lacking in details of the resolution process and ignores the issues of regulatory governance and strengthening the dispute resolution machininery. See here and here. With our weak track record on performance of regulators and the efficiency of quasi-judicial tribunals, we must ensure that the law lays down a strong foundation for the bankruptcy process and institutions to function efficiently. When India built its first few regulators, it arguably did not have the benefit of the knowledge of good regulatory governance practices. Over the years, much more knowledge about the working of regulators has been obtained, which has been embeddd into policy projects such as the Indian Financial Code and the Regulatory Reform Bill. The Bankruptcy Code should reflect the learnings in these areas over the last few years, and raise the bar for the performance of the newest regulator, the bankruptcy regulator.
2. The Code envisages new institutional infrastructure for the insolvency regime, namely, insolvency professionals and information utilities. The functioning of these two new competitive and regulated industries is key the success of the Bankrutpcy Code. Considerable thought and research into international best practices will be required for designing the regulatory architecture of these industries. The government must simultaneously begin work on constructing institutional capacity on these fronts.

Specialised resolution regime for resolving financial firms

The Budget proposes to introduce a law to deal with resolution of financial firms. This will complete the legal architecture for resolution of firms in the economy. As with the Bankruptcy Bill, a well crafted bill holds the key to the implementation of an effective resolution regime. Failure of a financial firm is distinct from the failure of a non-financial firm firm and the general bankruptcy process will not suffice for certain kinds of financial firms such as banks and systemically important financial institutions. For an understanding of why some financial firms warrant a specialised resolution regime, see this.

The FSB's document on The Key Attributes of Effective Resolution Regimes for Financial Institutions serves as a useful guidepost for jurisdictions proposing to introduce a framework for resolution of financial firms as part of their financial regulatory architecture. The FSB emphasises that the objective of an effective resolution regime is to resolve troubled financial firms without ``exposing tax-payers to loss, not relying on public solvency support and not create an expectation that such a support is available." Drawing on the FSB's principles and international best practises, the Financial Sector Legislative Reforms Commission has a chapter and a draft law on resolution. The chapter and the draft law elaborates on the objectives, powers, instruments of resolution and provides for an intervention framework at each stage of the financial health of the firm with a clear articulation of the roles of the regulator(s) and the resolution corporation.

There are three important features of a good resolution regime that the government should particularly bear in mind while preparing the law on resolution:

1. The authority in charge of resolution must be independent of the prudential regulator. This is because the resolution authority must intervene dispassionately to resolve a financial firm on the brink of insolvency and not be privy to any regulatory forbearance that is often exhibited by regulators toward the regulated. This has been a problem with the RBI in the past.
   
   
2. The law must allow the resolution authority to intervene before the financial institution is insolvent. This will require (a) immense co-ordination between the resolution authority and the prudential regulator throughout the life of a financial firm; and (b) clear articulation of roles of the resolution authority and the prudential regulator at each stage of financial health of the firm.
   
   
3. Resolution is a specialised task which requires analytical ability to understand the signals of potential distress in firms, weigh the various resolution options and promptly resolve a firm. Hence, it must be staffed with people having deep expertise in the field.
   

In addition to tabling a law on resolution, a rejig of the present legal and institutional machinery needs to be undertaken. The Deposit Insurance and Credit Guarantee Corporation (DICGC) has some experience in dealing with failing banks but lacks the capability to promptly resolve a failing financial firm. What will be the role of the DICGC? Will this be merged with the resolution corporation? What are the amendments required in the Acts such as the Banking Regulation Act to delink the regulatory function from the resolution function? All these issues need to be addressed to achieve an optimal resolution framework.

Reform of the asset reconstruction industry

One useful idea in the working of the credit market is to establish conditions for transactions, where conventional lenders sell assets to specialised debt recovery funds. In the confusing Indian jargon, these termed `asset reconstruction companies', but they are really stressed asset private equity funds. While ARCs have been around for a while, mistakes in their regulation have held them back from playing a useful role. The Budget promises to make the following reforms in relation to asset reconstruction industry, in the hope that this will enable asset reconstruction companies (ARCs) to acquire NPAs from Indian banks with renewed vigour:

1. Presently, foreign investment in the capital of an ARC is allowed to the extent of 49% under the automatic route. Foreign investment in excess of 49% of the paid-up capital of an ARC requires FIPB approval. The Budget promises to liberalise this and allow foreign investment in an ARC to the extent of 100% under the automatic route.
   
   
2. Presently, FPIs are allowed to invest to the extent of 74% in each tranche of a scheme of security receipts (SRs). The investment is subject to sectoral caps and the caps imposed on FPI investment in corporate bonds. The Budget promises to allow 100% FPI investment in each tranche of a scheme of security receipts. While this was long overdue, the condition on sectoral caps should be dispensed with. This is because the foreign funds used for subscription to SRs will be used by the ARC to acquire NPAs, with the objective of realising the cash flows due from them. To that extent, the foreign funds are not used to run an operating activity in the relevant sector. Security receipts do not represent an equity interest in a company. Hence, the application of sectoral caps to foreign investment in SRs is redundant.
   
   
3. Presently, a sponsor of an ARC is not allowed to hold a controlling interest in the ARC. This restriction is proposed to be dispensed with to allow sponsors to hold upto 100% of the paid-up capital of an ARC. While this is a good proposal in itself, it must be circumscribed with a caveat, namely, banks must not be allowed to hold a controlling interest in an ARC. Where a bank holds a controlling interest in an ARC, there is an inherent conflict of interest between the bank's obligations to its depositors and its interest as a controlling shareholder in the ARC. For instance, it creates incentives for a bank to hive off potentially recoverable assets from the bank's balance sheet to an ARC which it controls, to the prejudice of its depositors. Monitoring this conflict of interest and identifying whether the transaction between the bank and the ARC took place on an arm's length basis, is extremely difficult, if not impossible.
   
   
4. Presently, only institutional investors are allowed to subscribe to SRs on a private placement basis. The Budget promises to allow non-institutional investors to subscribe to SRs. However, this must be preceded with deep-rooted structural reforms. SARFAESI allows SRs to be issued to institutional investors through private placement. SRs are akin to units of funds which invest in risky assets. To allow liquidity to investors in SRs, the regulatory framework must allow SRs to be listed on Indian exchanges and globally. Further, the subscription-base for SRs must be phased out. In the first few years, sophisticated non-institutional investors must be allowed to invest. Once we have a strong consumer protection and enforcement framework in place, the participation can potentially be expanded to retail consumers.
   
   

Strengthening Debt Recovery Tribunals

The Budget Speech promises to strengthen the institutional infrastructure of debt recovery tribunals to enable better recovery of stressed assets. It makes specific reference to computerisation of court cases. As discussed here, several jurisdictions have a dedicated agency which handles the administrative tasks of the tribunal. The task of separating out the administrative functions of a tribunal and allowing it to be outsourced to a professionally managed agency is one of the structural reforms that can potentially enhance the performance of debt recovery tribunals. Similar measures should be taken to strengthen the NCLT which is the tribunal vested with insolvency jurisidction for corporates.

Conclusion

In the past, reforms of the credit market were often relatively superficial, and only involved RBI and banks, which are only a small part of the Indian credit market. Budget 2016 has begun a process of institution building on the credit market in important ways. These initiatives are not limited to banking and look at the working of the credit market in a deeper way. If these initiatives are carried through to fruition, they will constitute important reforms.


The authors are researchers at the National Institute for Public Finance and Policy.