Prevent contagion, preserve value

It's time to dam the financial sector against a bad debt flood

With the pandemic showing no signs of abating and hopes of sharp economic recovery to pre-pandemic levels receding, dark clouds are gathering on the horizon for India’s beleaguered financial system. While the largest US banks have squirrelled away billions of dollars in anticipation of a wave of de­faults, and the UK is considering a host of proposals, including swapping debt with the government in return for equity stakes and setting up a bad bank, we are yet to see concrete measures being undertaken in our country.

As was highlighted in the co­mments by Reserve Bank of In­dia (RBI) Governor Shaktikanta Das, with non-performing assets at record highs, a surge in bad debt can cause serious dislocations in the financial markets. Moreover, the presence of vulnerable Non-Banking Financial Company (NBFC) shadow banks will am­pli­fy the effect of the crisis on the financial sector.

Several measures have been mooted to prepare for the incoming bad debt train. These include capital buffers for private ba­n­ks/NBFCs, recapitalisation of PSUs and the formation of a Re­solution Corporation to manage failed financial institutions. Ca­pi­tal buffers for private banks and NBFCs are good measures in the­ory, but problematic both in terms of implementation and having ve­ry adverse side effects. Private ba­nks and NBFCs cannot be forced to raise capital unless mandated by the RBI through a diktat. This will likely cause distortions in the market for bank capital and will be viewed negatively by shareholders of private banks and NBFCs, thereby leading to a permanent increase in their cost of capital. Moreover, increasing capital requirements for financial ins­titutions will also increase the cost of funds and thus lending rates, which is likely to affect recovery, and should be avoided. 

Also economic research shows that capital buffers lower lending by banks (Berrospide and Edge, 2019, Federal Reserve Board), whi­ch is undesirable in the current ci­rcumstances. While private banks and NBFCs can be encouraged to raise capital, given the current valuations/yields, many might be reluctant to bite the bullet and prefer to ride out the storm.

Blanket recapitalisation of PSU banks may not be optimal at this point in time as well. It is going to take up considerable fiscal space, which is currently at a premium and may also be redundant given that PSU banks operate under an implicit sovereign guarantee and the markets are well aware of the fact that the RBI will not allow a PSU bank to fail. With respect to PSU banks, the optimal strategy may be to perhaps provide explicit sovereign guarantees in their favour for the next year and recapitalise only those banks that are at risk of eroding their capital to below statutory levels on a case by case basis. This will not only assuage the markets and motivate PSU banks to expand their balance sheets, but also save precious fiscal space for the government.

The strongest embankment against the expected flood of bad debt is going to be a Resolution Corporation. As Governor Das pointed out, this was part of the Financial Resolution and Deposit Insurance Bill, 2017. The most critical element in a financial dislocation is time. As a large financial entity starts failing, confidence in the financial system plummets quickly engulfing otherwise healthy firms until the crisis becomes self-fulfilling. What is required to stem such contagion is to nip the looming failure of a financial institution in the bud before it infects the rest of the system. What this means that a Resolution Corporation needs to act swiftly and decisively without wasting time. Quick corrective action from a Resolution Corporation will not only prevent contagion from spreading, but also preserve the business value of the firms in distress. However in the form it was envisaged in the Bill, a Resolution Corporation is likely to be constrained from acting optimally. 

One, the health of each financial firm will have to be monitored proactively and the conditions under which the Resolution Corporation will intervene should be defined objectively. Once those conditions are met, intervention should be swift. This is required since having vague intervention criteria leads to an extended period of uncertainty that harms confidence in the sector as was seen in the needlessly extended drama over Yes Bank and IL&FS. Two, the objective of such a Resolution Co­r­po­ration should be to preserve the value of the distressed firm. In order to do this, absolute priority rules should be defined clearly to minimise uncertainty. This was certainly missing in the Yes Bank bailout where AT-1 bondholders were wiped out, while legacy equity holders were not. And three, in order to empower the Resolution Corporation to prevent contagion and preserve va­lue, it should be seeded with capital, which it can invest in firms that are bankrupt in order to prevent unnecessary liquidation and preserve business operations till a suitable private investor is fou­nd. This capital can come from the funds saved by the government by avoiding blanket recapitalisation of PSU banks.

In sum, there is considerable uncertainty about the effect of the pandemic on financial system stability. The threat of a severe dislocation brought about by the collapse of a large financial institution cannot be ruled out. While capital buffers and recapitalisation of PSU banks are well-intentioned measures, they are likely to be inefficient and counterproductive. The most efficient tool to stem a future crisis in the financial sector is a well capitalised Resolution Corporation that is governed by transparent and clear rules. The creation of such an entity will in itself give confidence to the financial sector and will act as a buffer against the risk of contagion.

The author is director at Arrjavv & a “probabilist” who researches and writes on behavioural finance and economics