How the debtor creditor equation is affecting banks

This changing debtor-creditor equation disturbs the status quo and it is only natural that it is facing resistance. The earlier debtor-friendly environment made it possible for the defaulting debtors to secure moratoriums and force write-downs on debt repayment, while retaining management control over the borrowing units or thwart banks efforts to realise their dues by indulging in serial litigations. The out-of-court restructuring mechanisms too suffered high failure rates resulting in the borrowing entities continuing to indulge in repeated defaults, being confident that the balance of power remained with them and the ability of banks to discipline errant borrowers was weak.

 

The debtor friendly environment had its effect on banks’ business preference, while also partly contributing to the ever-increasing stressed assets in the banking system. Banks’ ability and/or willingness to lend to persons or entities that needed credit were hampered. The Bankruptcy Law Reforms Committee (2015) has observed and I quote:

“When creditors know that they have weak rights resulting in a low recovery rate, they are averse to lend. Hence, lending in India is concentrated in a few large companies that have a low probability of failure. Further, secured credit dominates, as creditors rights are partially present only in this case. Lenders have an emphasis on secured credit. In this case, credit analysis is relatively easy: It only requires taking a view on the market value of the collateral. As a consequence, credit analysis as a sophisticated analysis of the business prospects of a firm has shrivelled.”

In India, before the enactment of IBC, the Reserve Bank as banking regulator had to design resolution mechanisms that tried to emulate the desirable features of a bankruptcy law as identified in the literature. However, in the absence of a bankruptcy law in the country, those schemes could not result in meaningful resolution of the stressed loans. This resulted in significant mismatches between the book values of loans carried by banks and the inherent economic value of those loans. In this context, the enactment of the IBC is a watershed event, which has completely changed the legal framework governing the insolvency regime in the country. The enactment of IBC also enabled the Reserve Bank to come out with a revised framework for resolution of stressed assets. As observed by the Hon’ble Supreme Court of India, the judicial system of the country has internalized the paradigm shift in the law and defaulting debtors’ efforts to stymie the insolvency regime with frivolous litigation have not met with success so far.

In this context, it needs to be recognised that when banks take recourse to legal remedies available to them when a borrower defaults on his debt servicing, including that of security enforcement, they are essentially trying to recover the depositors’ money from a defaulting borrower, whatever be the reasons for default. However, the defaulting borrowers portray such an action by banks as a case of a ‘ruthless big bank’ taking over the assets of a ‘hapless borrower’. This is the kind of portrayal used even by the large corporates. 

Fallacy of ‘genuine’ defaulters

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One argument that we hear quite often is that there are different reasons for default, and the regulations should treat them differently based on the reasons which lead to the default. The proponents of this line of thought argue that where the borrowers are affected by external factors beyond their control, they should be treated as ‘genuine’ defaulters and some leniency in prudential norms is warranted. This is a fallacy, even though it is important to appreciate that some defaults are inevitable part of lending business. There are two issues here: recognition and resolution. The recognition of default or accounting for deterioration in the quality of asset should be independent of the reasons for such default or deterioration. Whereas, it is the resolution plan which should be a function of ability and willingness of the borrower to honour his obligations. Where a borrower has temporarily lost his ability to pay due to circumstances beyond his control, a quick and efficient restructuring of the debt either outside the courts or within the insolvency framework would be in order. In case of wilful or strategic defaulters, i.e., borrowers with the ability but no willingness to pay up their debt, change in ownership accompanied by punitive action against the defaulting management is the way to go. Finally, if the business is beyond revival, faster liquidation would help in reallocation of resources to productive use. This is what the Revised Framework for Resolution of Stressed Assets seeks to achieve. 

Another fallacy is the claim by the managements of defaulting borrowers that the restructuring plan proposed by them will result in ‘zero haircut’ for banks; whereas, if banks file insolvency application, new investor would be willing to take over the defaulting entities only with ‘huge haircuts’ on debt. What one needs to understand is that while the payments offered by the existing management are usually spread over a long period, the new investors mostly come up with upfront cash payments. The choice before banks is: ‘illusory future payments’ vs ‘upfront real cash’. Banks need to arrive at the present value of ‘illusory future payments’ by discounting it for time value of money and more importantly for the uncertainty in receiving the payments taking into account the existing management’s past records.

In almost all such cases, the society ends up underwriting the limited liability enjoyed by the shareholders through bearing the cost of default through lost jobs, concessions granted by the state, and above all, the haircuts taken by banks, which are in fact potential losses of depositors’/taxpayers’ money. Societies allow companies in default to reorganise themselves and attempt a resolution by allowing to renegotiate and rewrite private contracts under a formal bankruptcy mechanism. 

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Edited excerpts from a speech by N S Vishwanathan, Deputy Governor, Reserve Bank of India, October 29, 2018, delivered at XLRI, Jamshedpur on Some Thoughts on Credit Risk and Bank Capital