Using the bankruptcy code for privatisation of state owned firms that have a negative value

by Ajay Shah

In the past, we have seen privatisation as a sale of equity shares. As an example, consider the VSNL privatisation. Everything else about VSNL was held intact; there was just a change in the owner of the equity shares.

This works for a firm like VSNL, where there is positive value after paying off all the liabilities. What about a firm that is so far gone that there is no bidder if we put up the shares for sale? What about the situation where the prospective cashflows from the firm don't pay for the liabilities that are in place.

As an example, consider a firm that has Rs.100 of equity that is all owned by the government, the firm has Rs.200 of debt, and the firm is worth Rs.50 if it is sold as an all-equity firm. If we simply try to sell this firm, buyers will worry about having to take responsibility for Rs.200 of debt.

India has not done a privatisation in such a situation so far. There are two ways out, one that was always possible, and one that is now possible using the Insolvency and Bankruptcy Code of 2016.

One way is to permit negative bids

As an example, in Germany, in 1990 a government agency was created which was put in charge of all the property of the previous German Democratic Republic (GDR). It led the privatisation of 8,500 state owned firms with over 4 million employees. Many of those firms were in deep trouble. A key ingredient which made the privatisation strategy work was that negative bids were permitted.

In our example, the auction will reveal a price of -150. The government will pay the buyer Rs.150, who will augment it with Rs.50 of his own, and pay off the debt of Rs.200. At the end of this, he is holding an all-equity firm which has cashflows worth Rs.50.

In this case, the lenders get Rs.200, and the government gets Rs.-150. The payment of Rs.150 is an ordinary fiscal expenditure for the government.

The other possibility is to utilise the bankruptcy code

1. The firm defaults on one payment.
2. One creditor initiates the Insolvency Resolution Process under the Insolvency and Bankruptcy Code, 2016.
3. The creditors committee is formed.
4. The bidder comes in with a plan which offers Rs.50 for control of the company.
5. The creditors committee agrees to wipe out the debt, take the Rs.50 in the bargain, and walk away.
6. In the end, the bidder gets a clean all-equity firm for the price of Rs.50.

This is a method for privatisation that can now be used in India, when we face firms which have a negative net worth and the creditors will cooperate with the government.

In this case, the lenders  get Rs.50, and the government gets 0.

Conclusion

Financial engineering cannot create value. The fact, in our example, is that the NPV of the cashflows of the company are worth Rs.50. The two solutions address this problem in two different ways. If we do a pure transaction involving equity shares only, then the government has to pay Rs.150, and the lenders are fully protected. If we put the firm into the bankruptcy process, the government (i.e. the equity shareholders) walks away with nothing, and the lenders walk away with Rs.50.

Concerns about how the Medical Council of India thinks about medical malpractice

by Shyama Nagarajan and Shubho Roy.

India has approximately 5.2 million medical negligence cases annually. A study for Mumbai showed that medico-legal cases, in courts, against doctors rose from 910 in the period from 1998 and 2006, to 150-200 cases every year.

The responsibility to regulate the medical profession lies with the Medical Council of India: a statutory regulator. However, we get little information about whether or when the Medical Council of India (MCI) disciplines doctors. MCI seems to follow a moralistic approach to regulation rather than a legalistic approach.

Morals v. Laws

A legal system differs from a moral system in three important ways:

1. Specificity: Moral standards are usually generic, and rarely provide clear direction for action, in individual situations. In contrast, legal standards strive to be specific and are cognisant of exceptions to the rule. For example, a moral standard may be a generic statement like: Thou shalt not kill. Law, on the other hand, recognises that killing may be justified under many conditions, like defending oneself from a murderous attack, soldiers killing the enemy, an executioner killing the condemned. All of this is codified in various laws justifying killing of another human being in specific circumstances. These have been extensively thought through and developed through legislation and jurisprudence.
2. Consequences: Morals statements may prohibit some actions, but rarely have provisions to deal with the consequences of violating them. In contrast, laws focus on consequences of violating proscriptions. For example, a moral principle may be drafted as: Thou shalt not kill. The Indian Penal Code, on the other hand, has no statement prohibiting people from committing murder. It states simply: Whoever commits murder shall be punished with death, or imprisonment for life...
3. Enforcement Mechanism: Modern states do not enforce moral principles. For example, there is no enforcement mechanism for people who violate the commandment:"Thou shalt not kill". In contrast, laws are backed by the requisite vast machinery enforcing them. This includes police, judiciary and other supporting laws like law governing trials (Cr.P.C.), evidence, etc.

Medical Code of Ethics

MCI drafted the The Medical Code of Ethics, 2002 ("the Code") to govern medical practitioners. By using the term `ethics', it appeals to a moral principle. However, all aspects of the MCI constitute a legal system under the authority of Parliamentary law (the Medical Council of India Act, 1956). An analysis of a few provisions of the Code shows that while the MCI seems to claim moral authority: It drafts standards in the moral style. Even if it had systems and procedures in place to enforce these standards; the language of the standards would prevent them from being enforced in a legal system.

Let us apply these ideas to reviewing review three parts of the Code, pertaining to medical records, generic drugs and commissions.

Medical Records:

Section 1.3.1: of the Code states:

Every physician shall maintain the medical records (sic) pertaining to his/ her indoor patients for a period of 3 years...... in a standard proforma... attached as Appendix 3.

Appendix 3 expects the doctor to mention: Name of the patient, age, sex, address, occupation, date of 1st visit, clinical note (summary) of the case provisional diagnosis, investigations advised, observations, signature in full, and name of treating physician, etc. The record-keeping obligation on physicians is limited to ``indoor patients'' only. Indoor patients refer to patients in medical establishments (hospitals, nursing homes etc.) for 24 hours or more.

This provision suffers from three defects:

1. Incomplete coverage: This provision covers a very small proportion of patients that a doctor examines. It completely excludes the vast majority of interactions (such as, chronic case management and procedures) between doctors and patients, i.e. outpatient visits. There is no obligation to keep records or even record prescriptions in any standard manner for those interactions.
2. It duplicates work: Medical establishments (hospital, nursing homes, etc.) are already required to keep records for indoor patients. It makes no sense for individual doctors to duplicate the effort. Doctors admit patients in different hospitals and offer consultations, and make clinical rounds in hospitals seeing scores of patients. Maintaining records for each patient/prescription in person with the doctor (not the medical establishment) is irrational.

The code does not specify how MCI will identify and enforce against non-compliance. Neither through legal instruments associated with the MCI, nor through any other enactments, is there an enforcement apparatus which involves issues such as accepting complaints, carrying out inspections, requiring the submission of operational data, etc.
Section 1.3.4 of the code reads:

Efforts shall be made to computerize (sic) medical records for quick retrieval

This is an exhortation and cannot be enforced.

Generic names of drugs:

This provision is designed to prevent doctors from prescribing brands in return for kickbacks from pharma companies. This problem is so endemic that the government proposes to bring a new law to tackle it. The Code has a provision governing this, in Section 1.5:

Every physician should prescribe drugs with generic names legibly and preferably in capital letters, and he/she shall ensure that there is a rational prescription and use of drugs.

This obligation does state a penalty for violation. The code expects that there should be a rational prescription without any form to verify it. Since there are no standards for how prescriptions have to be written for patients, it is impossible to test compliance. A doctor is not required under the Code to write down the diagnosis. Consequently, it is impossible to verify whether the prescription was rational. There are medical texts and standards in training which specify how a prescription is written. However, the code makes no obligation on doctors to follow them.

Commissions

Kickbacks from pharma companies to doctors have become a major problem in India. In February 2016, the MCI amended the Code to insert a new provision governing payments received by doctors from pharma and medical technology firms: clause 6.8.1 of the MCI code. This provision is very different from the other provisions in the Code. It clearly leans towards a more legal system rather than a moral system:

1. Instead of a general prohibition, commissions have been divided into eight headings: Gifts, travel facilities, hospitality, cash or monetary grants, medical research, maintaining professional autonomy, affiliation, and endorsement.
2. Each heading has a definition of what constitutes violation. An example of this is the heading: cash or monetary benefits. While this prohibits receiving money from pharma companies, research grants have been exempted, which could be given to an arm of a hospital.
3. For each type of violation there is a specific penalty. For some, it has been graded depending on the magnitude of the violation. For example, if a doctor receives cash above Rs.1000 and up to Rs.5000 he is liable for censure. However, for receiving cash more than Rs.50,000 but up to Rs.100,000, the penalty is removal of the name from the medical register, i.e. barring from practice, for one year.

As with the other areas, these rules are ineffectual as the MCI has no system of tracking such gratification or the administrative machinery required to investigate and penalise violators.

There are grave problems in India about corruption of doctors in prescribing drugs. We need to do much more in defining and enforcing against these practices. One novel mechanism is found in the US. The government requires doctors and pharma companies to disclose any payments from pharma companies to doctors. There is a website where you can look up your doctor and see what payments he/she has received from the pharmaceutical sector (including medical device manufacturers): Open Payments Data. This has spawned other websites which allow users to analyse the data. Dollars for Docs have used the data to rank doctors and pharma companies.

The way forward

The regulation of medical profession requires a clear understanding of general principles of regulation. There have been many attempts to reform the medical profession, the latest being the Niti Aayog draft bill. However, legislative provisions which drive a sound regulatory process under MCI are missing.

Most drafting of law in India is done by amateurs and lawyers. Drafting laws is, however, not trivial. It requires sound thinking in public administration, law, and economics. There is an entire life cycle of a regulatory system which has to be designed in the law. The typical lawyer, who can support a private person on the legal ramifications of a transaction given a certain section of law, is unable to think about what the law ought to be.

Every regulatory system must be animated by a clarity of objective. The parent law must provide the objectives that should drive the government apparatus that it constructs. Too often we draft Parliamentary law which lacks objective. For example the objective of the Payments and Settlement Systems Act is:

An Act to provide for the regulation and supervision of payment systems in India...

The lack of objective induces a government apparatus that only pursues political objectives and bureaucratic self-interest. The authors of the law need to write down why the law gives powers to regulate: issues such as safety of transactions, safe payment system, competition, innovation and consumer protection.

After regulations are made through a sound regulation-making process, powers and systems have to be put in place to check for compliance with those regulations. This requires powers to obtain information, inspect and in some cases investigate. This requires procedural laws to govern inspections and investigations. It also requires thinking about the State capacity in the regulator. Should a regulator make a law where it has no capacity to check compliance? In health, this problem is compounded by the concept of doctor patient confidentiality. As in banking, we need to develop systems by which regulators can check for compliance without breaching the privacy of customers.

There is great value in using statistical analysis rather than case by case analysis. For example, if the incidence of cesarean operations in one hospital is substantially more than another hospital serving a similar population, the regulator should ask questions. Even for individual doctors, complaint rates rather than individual complaints may help the regulator identify the problem doctors. Such systems require careful recording and classifying complaints, even when they are not investigated.

Every regulatory system needs a quasi-judicial system to penalise or acquit the accused. Penalties should be imposed only after following principles of natural justice and due process. Both patients and the regulator itself should be able to bring complaints and results of investigation before a judicial authority, which is not involved in the investigation. Such an entity should apply some standard of evidence and impose penalties. This requires additional regulations specifying penalties for different types of violations. Penalties have to be proportional to elicit the right response from the regulated. As was known many years ago:

Whoever imposes severe punishment becomes repulsive to the people; while he who awards mild punishment becomes contemptible. But whoever imposes punishment as deserved becomes respectable.  -- Chanakya ("Arthashastra", I. "Concerning Discipline", Chapter 4).

All these functions require additional provisions governing accountability and transparency expected of the regulator. Regulatory governance in any field requires substantial amount of legal drafting and two levels: the governing parliamentary law and the subordinate regulations made by the regulator. An example of this is the draft Indian Financial Code. While the code covers the entire financial sector including central banking, 135 out of 414 (32%) of the provisions deal with good governance practices in regulators and tribunals, and are a useful first draft for economic regulation in other fields.



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

NPA Ordinance: The impact of secrecy in ordinance making

by Pratik Datta and Rajeswari Sengupta.

In a liberal democracy law making should be a transparent affair. Transparency allows constructive public debate before a law is imposed on the society. In USA, the secrecy surrounding the drafting of the Senate Health Care bill meant to repeal Obamacare has been widely criticised. In contrast, we in India are so used to secrecy in legislative drafting that we do not even question it. We are content that bills introduced in the Lok Sabha and Rajya Sabha are at least publicly available.

Even this minimal transparency is denied to Indian citizens when the same bill is sent by the Cabinet to the President for 'promulgation' as an ordinance. The draft of the ordinance is not released in public domain till the President signs it and brings it into force. Unlike Parliamentary laws, there is no opportunity for public debate and discussion around a draft ordinance that has been approved by the Cabinet till it is imposed on the society. We saw this happen with the recent Banking Regulation (Amendment) Ordinance, 2017:

• There had been speculation in the media since March 2017 that the Government was planning to take steps to resolve the stressed assets problem in the banking sector.
  
  
  
  Figure 1: Google searches on 'NPA Resolution'
  The graph above plots data from Google Trends. It shows the interest over time in the words 'NPA Resolution'. The graph plots the number of web searches done between the weeks starting March 5, 2017 and May 14, 2017. From March 19 onward, there was a sharp increase in the number of searches that used the words 'NPA Resolution'. The interest subsided in the week starting April 23 and picked up significantly in the week starting April 30, the same week when the NPA ordinance was first announced and then publicly released. From March 2017 onward, there were also news in the media that the Government was planning to empower the Reserve Bank of India to deal with stressed asset problem (see here and here).
• On May 3, 2017 the Cabinet approved the Banking Regulation (Amendment) Ordinance, 2017. The media carried reports about the Cabinet approval but the text of the draft ordinance was not publicly available (see here and here). Around 7:49 pm on May 3, 2017, the Finance Minister mentioned in a media briefing that the Cabinet's recommendation has been sent to the President. He did not disclose any further detail on the ground that: There is a convention that when some proposal is referred to the President, then details of it cannot be disclosed till it is approved (sic).
• On May 4, 2017 the President signed the Ordinance. The text of the signed ordinance was still not publicly available.
• On May 5, 2017 the ordinance was released in public domain when it was uploaded onto the e-gazette at 12:38 PM.

In other words, even after the Cabinet approval on May 3, the text of the ordinance was withheld from the public till May 5. What was the impact of this secrecy convention? In this post we answer this question by examining the movement of the Nifty, the Bank Nifty and the PSU Bank Nifty indices before and after the public release of the ordinance.

Impact of the secrecy convention

Once the Cabinet provisionally agrees that an ordinance is needed, a bill is drafted. The draft bill is then sent to the President for promulgation as ordinance. As per the unwritten convention cited by the Finance Minister, the text of the ordinance is kept secret from the public till it gets uploaded on the egazette website. However, as seen during the promulgation of the Banking Regulation (Amendment) Ordinance, although the text was kept secret, selected information about the ordinance was released by the government to the media. There
was much speculation in the media about the details of the proposed ordinance.

Figure 2: Prices

The graphs above plot the three stock indices for the trading days around May 5. They run from the start of the trading day on May 2 to the close of trading on May 8. Trading was closed on the weekend of May 6 and May 7. The first two graphs from the top show the cumulated market model residuals of the Bank Nifty index and the PSU Bank Nifty index, respectively. The bottom-most graph shows the movement in the Nifty index around the event. The event identified in the graphs is the public release of the NPA ordinance at 12:38pm on May 5.

After the Finance Minister's press briefing on the evening of May 3, Nifty traded higher on May 4 than on the previous two trading days. Right after the ordinance was made public at 12:38pm on May 5, it fell till about 1:40pm before correcting marginally and ended the day lower than the previous two trading days.

A similar price movement is seen in the Bank Nifty index. The movement is much more pronounced in the PSU Bank Nifty index. Both the Bank Nifty and the PSU Bank Nifty indices went up between May 3 and May 5 (before 12:38 pm), the time period during which the secrecy convention was supposedly being followed. This suggests that the Finance Minister's media briefing on the evening of May 3 and the selective release of information was treated as positive news by the market. However the upward price movement came to a halt when the full text of the NPA ordinance was made public at 12:38pm on May 5 following which the prices fell sharply. The decline was more pronounced for the PSU banks.

It is worth noting that the prices had actually started falling a little before 12:38pm on May 5, particularly for the PSU banks. So it is possible that news of the text of the ordinance got leaked to the market even before the official release of the ordinance.

Figure 3: Volatility

The graphs above show the volatility in the returns of the three indices around the release of the NPA ordinance. There was an increase in the volatility of both the Bank Nifty and the PSU Bank Nifty indices after the ordinance was made public on May 5. The volatility increase was much more prominent for the PSU banks.

Market's negative reaction

The negative reaction of the market following the public release of the ordinance reflects the mismatch between market expectations and the final text of the ordinance. Between May 3 and May 5 (before 12:38 pm), market expectations were fuelled in the absence of the full text of the proposed ordinance. The selective release of information by the government triggered expectations in the market that the proposed ordinance would offer a comprehensive solution to the stressed asset problem of the banking sector. However, once the text of the ordinance was made publicly available at 12:38 pm on May 5, it was not evident to the market how the ordinance would be able to tackle the NPA crisis. The ordinance gave rise to more questions than it answered (see here). Consequently, the market reacted negatively.

Conclusion

Secrecy has been an inherent trait in ordinance-making since the times of the British Raj. Post-independence, while giving ordinance making powers to the President, the Constitution framers did extensively deliberate on the potential misuses of such powers. But they never questioned the secrecy around ordinance making. Consequently, Article 123 of the Constitution empowers the President to promulgate ordinances but does not explicitly require transparency in the ordinance-making process. It is then hardly suprising that even the Supreme Court has over time accepted that open legislative debates and discussions do not apply to ordinances.

It is high time we question this secrecy. As we have seen above, the secrecy convention coupled with the discretionary release of partial information about the recent Banking Regulation (Amendment) Ordinance, 2017 led to information asymmetry in the stock market, causing market inefficiencies. To avoid such inefficiencies, the government should make the ordinance-making process transparent by discarding the age-old secrecy convention and officially releasing the proposed ordinance immediately after it is approved by the Cabinet. Complete transparency in ordinance-making will also be in sync with the broader philosophy of legislation-making in a modern liberal democracy.

 

Pratik Datta is a researcher at the National Institute of Public Finance and Policy, New Delhi and Rajeswari Sengupta is a researcher at the Indira Gandhi Institute of Development Research

What happens to private airlines when Air India is privatised?

by Ajay Shah.

What's the impact of privatising Air India upon the rest of the domestic airline industry? Some think that the capital stock of Air India will now be put into more capable hands, and that will intensify competition. Instead of a feeble competitor with assets of Rs.546 billion, we'll have a strong competitor wielding those same assets.

As was argued by me in August 2009, the `zombie firms' literature helps us think about this. A zombie firm is one which ought to go out of business, but is artificially kept on life support. Sometimes, the subsidy is explicit, such as the fiscal injections into Air India. Sometimes, the subsidy is less visible, such as banks extending additional capital to bankrupt firms. Regardless of the method adopted, the basic fact stands: A firm that ought to have gone out of business was given a subsidy through which it sold goods at below cost.

To fix intuition, imagine a market price of Rs.100. Imagine a weak firm that, on its own, is only able to produce at Rs.110. This firm ought to rapidly vanish. But instead, it's given a subsidy of Rs.11 (either by the government or by banks) and it manages to sell at Rs.99. This keeps it going. This also harms the healthy firms in the industry, who have to deal with competition from this dead man walking.

Turning to Air India, in 2014-15 the firm produced a profit after tax that was -28.4% of total income. For each Rs.100 of total income, there was a loss of Rs.28.4. The overall industry was at -11.7%, and the industry average was dragged down by Air India which is a substantial player.

The presence of zombie firms harms healthy firms. It's hard for a healthy firm to compete against one that's getting a subsidy. By this logic, the exit of a zombie firm is good news for each firm left standing in the industry.

If one of the incumbent large Indian airlines buys Air India, the combination will have significant market power, which would be a suboptimal outcome. It would be nice, from the viewpoint of competition policy, if a new player buys Air India. In either event, the low and subsidised prices charged by Air India will end. This will improve the profitability of the domestic airline industry. All healthy firms benefit when we address the problem of zombie firms.

Air India's privatisation is an interesting milestone where we may see some of these effects play out. The issue of zombie firms is, of course, present in many parts of the Indian economy. We have a peculiar arrangement where zombie banks keep zombie firms alive. Disrupting these arrangements holds the key for starting India on the next bout of growth.

Interesting readings

How genetics is settling the Aryan migration debate by Tony Joseph in The Hindu, June 19, 2017.

The botanists' last stand: The daring work of saving the last samples of dying species by Zoe Schlanger in Quartz, June 17, 2017.

45 years of Watergate: Why the journalism of the Washington Post-NYT holds lessons for today's media by Saikat Datta in Scroll, June 17, 2017.

Dangerous nonsense: Once we put the Indian military above criticism we become Pakistan by Kanti Bajpai in The Times of India, June 17, 2017. Also see: How will your armed forces perform? by Ajay Shah in Ajay Shah's Blog, October 12, 2016.

Eyes in the forest by Aakash Lamba in Mint, June 17, 2017.

Where are India's TV comedy shows? by Mitali Saran in Business Standard, June 16, 2017.

Lessons from the US in Business Standard, June 15, 2017.

Modi's Message to the Media by Sadanand Dhume in The Wall Street Journal, June 15, 2017.

Keep official abuse of governance in check by Somasekhar Sundaresan in Business Standard, June 15, 2017.

The power paradox by Pratap Bhanu Mehta in The Indian Express, June 14, 2017.

Jeff Sessions and the Trail of Unanswered Questions by Amy Davidson in The New Yorker, June 14, 2017.

Want More Time? Get Rid of The Easiest Way to Spend It by David in Raptitude, June 13, 2017. Why did social media work badly? Perhaps an adverse selection process is afoot: a vicious cycle of low quality giving selective exit giving lowered quality.

Is Trump's definition of 'the rule of law' the same as the US Constitution's? by David Mednicoff in The Conversation, June 13, 2017.

Trump and the True Meaning of 'Idiot' by Eric Anthamatten in The New York Times, June 12, 2017.

Pirate Bay founder: We've lost the internet, it's all about damage control now by Már Másson Maack in Nextweb, June 10, 2017.

Donald Trump Is the Worst Boss in Washington by Britt Peterson in The New York Times, June 9, 2017.

The forking of the Indian rupee by J P Koning on Moneyness, June 9, 2017.

Blood from the Sky: Zipline's Ambitious Medical Drone Delivery in Africa by Jonathan W. Rosen in MIT Technology Review, June 8, 2017.

Bengal and business by Ashok K Lahiri in Business Standard, June 6, 2017.

Movement on the law for the Resolution Corporation

by Suyash Rai.

Capitalism without bankruptcy is like Christianity without hell.
- Frank Borman

On June 14th, the Union Cabinet approved the proposal to introduce a Financial Resolution and Deposit Insurance Bill, 2017 ("the FRDI Bill"). This is an important step forward for a critical component of the overall strategy of India's financial sector reforms. Shaji Vikraman has insight on this in the Indian Express. In this article, I look deeper into the concept of the resolution corporation, why it matters, how we got to this milestone, and what comes next.

The slow unfolding of the banking crisis reminds us of the fragility of our financial system. The financial system, especially the banking system, is generally disaster-prone. On one hand, financial firms can make mistakes and experience losses. In addition, there is a link between problems of the economy and hardship in financial firms. When an economic downturn happens, the value of business activities declines, and this induces losses upon financial positions. We need to build a financial regulatory apparatus which will reduce financial fragility. This involves three main elements of machinery : micro-prudential regulation (which aims to push the failure probability of each financial firm to a desired value), systemic risk regulation (which aims to reduce the probability of a disruption in the overall financial system, and have tools to respond to such a disruption when it does arise) and resolution (a specialised bankruptcy process for most financial firms). At present, in India, we have weaknesses on all three elements.

Consequences of a weak resolution system

When micro-prudential regulation works well, the failure probability of financial firms is at a low level chosen by the relevant financial agency. The failure probability is not zero. Failure of inefficient firms is essential for `creative destruction'. The process of failure of inefficient firms, and the shift of capital and labour to efficient firms, is essential for productivity growth. The question is: How can we make the failure of financial firms orderly?

The failure of financial firms can often be quite disorderly. Unlike real sector firms, many financial firms manage a large amount money belonging to households and businesses, with only a small amount of capital brought in by their owners. Banks in India typically have leverage of 18$\times$ to 20$\times$, which means that their balance sheet size is 18 to 20 times the amount of equity capital. Such leverage is never seen with real sector firms. When the firm gets into trouble, there is clamour by the creditors who want to see a fair and efficient process through which they get some of their money back. Matters are more challenging with some financial firms which are so large and complex that their failure could induce instability in the financial system.

An orderly failure is one where a) the consumers either get their money back quickly or continue to get services without any significant inconvencience, and b) the stability of the financial system is not threatened. If we are not able to obtain orderly failures in the financial system, this has many adverse consequences:

• Consumers of failed financial firms suffer. As an example, in India, many cooperative banks fail every year. In spite of high entry barriers, larger institutions also fail (e.g. Global Trust Bank in 2004). Consumers lose money in these failures. These bad experiences make consumers wary of engagement with the financial system, and increase the share of gold and real estate in their portfolios.
  
• Financial stability is threatened, because even if one systemically important financial firm fails, the entire system could be destabilised by a messy, long-drawn bankruptcy process. This forces government to bail out such financial firms. So, a financial crisis ends up having a fiscal consequence.
  
• When faced with the possibility of harm to consumers, and threats to financial stability, governments get cold feet in situations of firm distress. They are then prone to bail out financial firms using taxpayers' money. We in India are familiar with this story. Public sector banks are routinely recapitalised with public funds to ensure they do not fail. This is almost never a good use of public money.
  
• Regulators sometimes respond to these problems by setting up entry barriers, which harm competition and economic dynamism. They justify the every day harm to competition on the grounds that this averts harm to consumers, risks to financial stability and the fiscal cost of bailouts.
  
• Financial firms suffer from moral hazard, and take greater risks. At its worst, financial firms obtain supernormal profit from these two interlinked channels: the certainty of being bailed out and the lack of competition.
  

A system that ensures quick and orderly resolution of failed financial firms can help avoid these outcomes. The system should be such that government, financial firms and consumers believe that the failures will be orderly. The present system of resolution in India is inadequate.

First, it mostly empowers the respective regulators (eg. RBI for banks) to do the resolution. Since regulators give the licenses and are supposed to ensure safety and soundness of the firms they license, they tend to be tardy in acknowledging their mistakes. This regulatory forbearance leads to delays in recognition of failure, which increases the costs of resolution, and may lead to losses for consumers and increases risk to stability of the financial system. There is a conflict of interest between micro-prudential regulation (achieving a target failure probability for a financial firm) and resolution (gracefully closing down financial firms which are nearing failure).

Second, the present system gives very limited powers of resolution. The powers that are given are: forced mergers/amalgamation, and winding up. Some of the other powers, such as bail-in (discussed later), are not available.

Third, even these limited powers are not enjoyed over many of the financial firms. For example, regulators do not have resolution powers over public sector scheduled commercial banks and regional rural banks.

Fourth, the way the system is structured, a bankruptcy resolution can take years, sometimes even longer than a decade. This is partly because the regulators do not have powers to take timely resolution action.

The Financial Resolution and Deposit Insurance Bill

Indian policy thinking on this began in the RBI Advisory group on reforms of deposit insurance, 1999, chaired by Jagdish Capoor.

This slumbered until we got to the Financial Sector Legislative Reforms Commission, chaired by Justice BN Srikrishna, which worked from 2011 to 2013. In its full design of Indian financial regulation, it recommended a Resolution Corporation.

In 2014, a Working Group of Ministry of Finance and Reserve Bank of India, co-chaired by Shri Arvind Mayaram and Shri Anand Sinha, also recommended a resolution capability for financial firms.

In 2014, the Ministry of Finance constitued a Task Force for the Establishment of the Resolution Corporation, under the chairmanship of Shri M. Damodaran, to work out the plan for establishing the Resolution Corporation. This was part of the two-part creation of task forces for building the new institutions required in the FSLRC architecture, which came about as four task forces followed by one more.

The budget speeches of 2015-16 and 2017-18 announced a plan to draft and table a Bill on resolution of financial firms. In September, 2016, a draft of the Bill was placed in public domain for comments.

On June 14th, the Cabinet approved the proposal to introduce a Financial Resolution and Deposit Insurance Bill, 2017 ("the FRDI Bill") in Parliament. The FRDI Bill, when enacted, will create a framework to ensure that failure of financial firms is orderly. It will establish an independent Resolution Corporation tasked with resolving failed financial firms. The Corporation will also subsume the deposit insurance function presently performed by the Deposit Insurance and Credit Guarantee Corporation.

This Bill stands at the intersection of two long-term reform projects: 1) financial sector reforms, of which bankruptcy resolution of financial firms is an integral part; 2) bankruptcy reforms, of which financial firm resolution is an integral part. So, this Bill moves both these projects forward, and is an important building block for an efficient system of capital allocation in India.

FSLRC had envisioned a separation between the resolution corporation, which would apply for most financial firms, and the bankruptcy code, which would apply for the remaining financial firms and for all non-financial firms. The Bankruptcy Legislative Reforms Commission (BLRC), which drafted the Insolvency and Bankruptcy Code (IBC), worked with this scheme. IBC does not cover financial firms, unless the Central Government notifies certain financial firms to be covered under that law. Many types of financial firms, especially firms handling consumer funds and firms that are critical for financial stability, require a specialised resolution mechanism. For firms handling consumer funds (eg. banks, insurance companies), the process under IBC is not suitable, as a large number of small value consumers will find it difficult to invoke that process. The processes of IBC are designed for creditors who are firms, not individuals. For systemically important financial firms (eg. central counterparties, larger banks), a creditor-led resolution process under IBC is not suitable, because what is at stake is not just the interest of creditors but the stability and resilience of the financial system. Hence, for such financial firms a specialised resolution regime is required. The FRDI Bill will create such a specialised resolution regime.

What is resolution?

In the world of financial firms, resolution complements regulation. Regulators and the Corporation are expected to work in tandem, with the regulators focused on maintaining financial health and, when a firm gets into trouble, pushing for its recovery. The Resolution Corporation will take over and resolve a firm after recovery efforts have failed. Although the version of the Bill approved by the Cabinet is not yet in public domain, based on the version that was released for public consultations last year, the framework is divided into four stages.

First, when the financial firm is healthy, the respective regulators will monitor the firm and work to ensure it continues to stay healthy. At this stage, the Resolution Corporation will only get information indirectly through the regulators. Substantive powers to monitor the firm or to take any other action with respect to the firm will not be available to the Corporation.

Second, once the financial firm starts deteriorating, the respective regulator will attempt recovery. At this stage also, only the regulators will continue to have substantial powers over the firm.

Third, if the recovery efforts fail, and as the financial firm get close to failure, the Corporation will get substantial powers to instruct the firm to improve its resolvability and prevent actions that may erode the values of assets available for resolution. At this stage, the role of regulators is restricted.

Finally, when the firm fails, the Corporation will take charge and resolve it. Resolution typically means selling the failed financial firm, as a whole or in parts, to another financial firm via a competitive bidding process. However, resolution could also involve other instruments. For example, the firm could be "bailed-in", which means that the rights of and obligations to creditors may be written down to recapitalise the firm from within. Bail-in typically includes converting some junior debt into equity, but may also include writing down other types of claims. This is the opposite of a bail-out, wherein outside investors rescue a borrower by injecting money to help service a debt. Finally, liquidation may be a tool used for resolution.

There is a certain degree of tension and potential conflict between the Regulators and the Resolution Corporation. This is a healthy check-and-balance. Resolution works as a check on regulatory incompetence and forbearance. Both sides will need to be mature, respect the role of the other, and coordinate.

The idea of a specialised resolution regime for financial firms is well-accepted globally. The US has had a resolution system for banks for more than 80 years. The scope of this system was extended after the financial crisis of 2008. There have been more than 600 bank failures in US since the crisis. In this time, there has been not been even one bank run in the US, because depositors trust the resolution system to work. Why the crisis happened in the first place is another matter, which is beyond the scope of resolution. Resolution comes into play only after regulation fails, and the occurrence of crisis resulted from regulatory failure, among other factors.

Many other countries have put in place comprehensive resolution systems. These include: all European Union member states, Switzerland, Australia, Canada, Japan, Korea, Mexico, and Singapore. Many jurisdictions have ongoing or planned reforms to resolution regimes. These include: Australia, Brazil, Canada, China, Hong Kong, Indonesia, Korea, Russia, Saudi Arabia, Singapore, South Africa, Turkey.

Next steps

We are still a few years away from having a full-fledged resolution regime. Now that the Bill is going to the legislative branch, it remains to be seen what version of the Bill eventually gets enacted. If the essential features of a good resolution regime are diluted in the final version, the chances of success will be low.

Even after the Bill gets enacted, it would still take some time to build an independent and competent Resolution Corporation. Since this capability currently does not exist in the system, it will have to be cobbled together, and then strengthened over a period of time. Consider the example of human resource strategy. There are many models out there. While the Canadian authority works with fewer than 100 employees, the US authority has more than 10,000 employees. The Corporation could choose to run a tight ship, and rely on contractual work to scale up capacity in times of crisis, or it could choose to build a large organisation that is able to, on its own, deal with a crisis. Similarly, given the skill sets required to do this job, the Corporation will have to think innovatively about attracting top talent within the constraints of a government agency.

The Task Force on Establishment of the Resolution Corporation, led by M. Damodaran, has done considerable work that lays the groundwork for constructing the agency. The implementation of their project planning needs to commence immediately, so that the delay between enacting the law and enforcing it can be minimised.

It will also take our governance system some time to get used to this kind of a system of taking over and resolving a failed financial firm in a decisive and quick manner, as opposed to the present approach of allowing things to linger on. If things do go right, there are many potential benefits of this reform.

 

The author is a researcher at NIPFP.

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