Resolving stressed financial firms

A resolution corporation is required for the failure of banks, insurance companies, and systemically important firms

The resolution of stressed financial firms is a key bottleneck in economic policy today. Such resolution is no different from that of non-financial firms when the firm in question has not made intense promises to unsophisticated households. For financial firms such as non-banking financial companies (NBFCs), the plain Insolvency and Bankruptcy Code (IBC) is the right way to do resolution. A specialised statutory financial resolution corporation is for the limited class of problems, where the plain IBC approach will work poorly.

From 2011 onwards, a major problem in India has been stressed firms. When a firm has its back against the wall, normal business activities take the backseat, which adversely affects the economy. The credit market freezes when there is widespread fear that lenders will lose money. Efficient resolution procedures are essential in every market economy. India began on that journey with the enactment of the IBC in 2016. At the time, the IBC covered non-financial firms.

Consider a stressed NBFC such as IL&FS or Dewan Housing Finance. These firms have borrowed from professionals. They have no borrowing from unsophisticated households. Neither of these firms is systemically important. As a thumb rule, systemically important firms must have a balance sheet of at least 2 per cent of GDP. In India today, that is a balance sheet size of about Rs 4 trillion. HDFC is systemically important, but IL&FS or Dewan Housing Finance are not.

Under these circumstances, the plain IBC approach would work correctly. An NBFC would reach its first default. At that point, any one creditor would go to the National Company Law Tribunal (NCLT), and control of the firm would shift to the committee of creditors. The committee of creditors would comprise banks, mutual funds, and other professional lenders to the NBFC.

The committee of creditors would think about what is in its best interests: Selling the firm, first raising cash by selling parts of the book, restructuring its debt, or a liquidation. It has the right incentives and the right ability to solve the problem. In the event that the bankruptcy process imposes a loss, this would fall upon these professionals. Within about a year after the default, we could put the problem behind us.
 

At present, absent a resolution framework, lenders are plagued with uncertainty. The promoter decides the order of priority in which lenders get paid. In contrast, the IBC offers a predictable set of rules through which the resolution will proceed. Without the IBC, each creditor tries to get its own money out, and does not care about the resolution of the NBFC. A creditor today even pushes for harmful actions by the NBFC as long as such actions get it cash.

Under the IBC, all the creditors will negotiate a single solution to their shared problem under the auspices of the committee of creditors. The energy of all creditors will be channelled into finding the best resolution plan, which is able to achieve a super-majority in the committee of creditors.

This happy picture breaks down, particularly for banks, when there are unsophisticated households in the picture. Bank depositors are in a unique position — unlike lenders to NBFCs — in that they can take their money out at any time. The use of the IBC for banks would go wrong at two levels. First, it would make depositors jittery and prone to take their money out at the first hint of trouble. Second, it is hard to organise a negotiation between a large number of lenders in the committee of creditors.

This calls for a specialised statutory “resolution corporation” (RC) that will take control of a stressed financial firm. There are three unique features of such an RC. First, it will act pre-emptively, and swing into action slightly before the net worth has become negative: This is unlike the IBC, which only kicks in after default. Second, it will move faster than the IBC process as a lengthy negotiation between creditors is not required. Third, it will pay out deposit insurance to unsophisticated households, or reassign insured households to a new insurance provider.

Such a statutory financial RC was part of the design of the Financial Sector Legislative Reforms Commission (FSLRC). The design was done before the IBC. Now that the IBC is here, we should be careful to see the restricted role for this RC. An RC is required for the failure of banks, insurance companies, and systemically important firms (such as HDFC). It is not required for an ordinary NBFC such as IL&FS, where a plain IBC would suffice.

The establishment of an RC was attempted through the Financial Resolution and Deposit Insurance (FRDI) Bill, which was shelved. This remains an important policy priority and it should be pushed through. But we should recognise the limitations of this path. The RC will be a new government bureaucracy. Most government agencies in India work poorly, and the broad failures of public administration in India will hamper the RC also.

The RC features a remarkable power: It can initiate resolution of a bank before the bank has defaulted. It will take us many years to clad this power with adequate checks and balances, to avoid misuse. It will be difficult for officials in the RC to correctly intervene in a financial firm, just before its equity capital is about to become negative, and to find the optimal methods in resolution. Under good project management, it will take about three years to find its feet.

To summarise, for two kinds of problems in the resolution of financial firms — systemically important firms such as HDFC or firms that have made intense promises to unsophisticated households such as banks or insurance companies — there is no running away from the RC. This is a multi-year journey that should commence soon. But for all other financial firms, the interests of lenders who negotiate within the committee of creditors will work better than the bureaucracy of the RC. We need to do more on making the IBC work well, and need to place the resolution of a large class of financial firms in it.

The writer is a professor at National Institute of Public Finance and Policy, New Delhi