Firm insolvency process: Lessons from a cross-country comparison

Firm insolvency process: Lessons from a cross-country comparison The Leap Blog, December 22, 2015 (with Anjali Sharma).

To internationalize the rupee or not?

Mint, December 2, 2015 (with Bhargavi Zaveri)

The recent decision by the International Monetary Fund to include the Chinese renminbi in the Special Drawing Rights basket and announcements by the Reserve Bank of India (RBI) allowing Indian companies to issue offshore rupee-denominated ‘masala’ bonds have triggered discussions on whether India is ready to ‘internationalize’ the rupee.

In popular discussions, rupee internationalization is often seen as a goal in itself. The notion that there needs to be a specific agenda for internationalizing the rupee is wrong.

To explain this proposition, it is necessary to understand what is an international currency. Rupee will be an international currency if non-residents are willing and able to trade in it and invest in rupee-denominated assets. For example, a Russian importer must be able (and willing) to invoice and pay for her imports from South Africa in rupees. Similarly, a UK resident must be able (and willing) to invest her savings in rupee-denominated bonds or shares. In these cases, non-residents take risks in the rupee as a currency.

The willingness and ability to transact and invest in a currency depend on three prerequisites. First, the issuing country must have sufficient scale, both in terms of nominal gross domestic product and volume of international transactions. For instance, while China is a $10.36 trillion economy, India is roughly at $2 trillion. For India to attain sufficient scale, the economy needs to grow at a sustainable average rate of 7-8% for the next five years or so. India’s current share of global trade is also relatively small and the bulk of it is invoiced in US dollars. Improvements in scale are linked to macroeconomic fundamentals, which cannot be changed through an internationalization-driven agenda.

Second, the value of the currency must be stable over time. A currency is considered stable when the general level of prices does not vary too much. Stability has multiple aspects: macroeconomic, financial and political. On macroeconomic stability, earlier this year, India undertook an important reform in the form of the Monetary Policy Framework Agreement that formally lays down inflation targeting as the objective of monetary policy in India. The proposed Monetary Policy Committee (MPC) Bill, if introduced and passed, will complete this reform by institutionalizing an accountable and transparent decision-making framework for monetary policy.

Not much progress, however, has been made on financial stability. The banking system continues to be overburdened with burgeoning non-performing assets. None of the attempts undertaken so far by either the RBI or the government to resolve banks’ asset quality problems seems to be yielding expected results. Improving financial stability will need urgent reform of the banking system and strengthening banking regulation.

In terms of political stability, the fact that India is a democracy, like issuers of most international currencies in the 19th and 20th centuries, goes in its favour. Democracy and associated checks and balances on the executive, instil confidence in foreign investors about the policy credibility of the government, thereby imparting stability to the national currency.

Stability is often confused with a managed currency that does not exhibit volatility. This is wrong. A currency is deemed stable when its value reflects underlying market forces. If market forces cause a currency to fluctuate, then artificially managing its price does not make it stable. One way to look at this problem is to think of administered prices. There was a time in India when prices of commodities such as steel and diesel were controlled and exhibited no volatility. Today, these prices freely fluctuate in response to supply and demand conditions. That is how a currency market should work as well.

Third, the currency must be liquid. A currency is liquid if significant quantities of assets can be bought and sold in the currency, without noticeably affecting its price. This requires depth in financial markets, a large stock of domestic currency-denominated bonds and adequate options to hedge currency risk exposures. India lacks a deep, liquid and well-functioning corporate bond market. Hedging opportunities for foreign investors are limited. On the exchange side, RBI and Securities and Exchange Board of India (Sebi) control the kind of currency derivative products that can be offered by exchanges, mandate underlying exposure requirements to buy those products and set position limits. Off exchange, there are entry barriers on who can offer and trade in currency derivative products, and on what conditions. Extensive regulatory reform is required to create a deep market that will offer foreign investors suitable hedging options.

Liquidity has been historically found to be less in countries that have capital controls. A large base of foreign investors adds to the liquidity in the domestic market. India has one of the least open capital accounts among emerging economies. Relaxing capital controls to attract foreign investor participation is crucial for enhancing rupee liquidity.

To conclude, any conversation on rupee internationalization dehors structural reforms is futile. Scale, stability and liquidity can be achieved through strong economic fundamentals and a process-driven regulatory environment. These, by themselves, are important policy goals to achieve for India. It is possible that once these are achieved, the rupee will come to be accepted as an international currency.

Road to insolvency resolution

Mint, November 26, 2015 (with Richa Roy)

The current corporate insolvency resolution framework in India fares poorly in terms of timeliness and costs of proceedings. The longer the time taken, the more the erosion in realizable value of assets and the lower the recovery rate—the ultimate parameter for evaluating the strength and efficiency of an insolvency framework. Inordinate delays in resolution arise from a lack of clarity regarding legal provisions, an overburdened judiciary, information asymmetry faced by creditors, absence of well-defined timelines stipulated in the law and an overall weak enforcement mechanism. Institutions that should support the resolution process such as dedicated tribunals, official liquidators and credit bureaus are severely capacity-constrained. All these culminate in a recovery rate of roughly 20% of the value of debt—among the lowest in the world. Bankruptcy reforms in India must therefore focus on minimizing delays.

The Insolvency and Bankruptcy Code (IBC) proposed by the Bankruptcy Law Reforms Committee (BLRC) addresses the timeliness issue by stipulating a strict timeline of 180 days for insolvency resolution and limiting judicial determination at the trigger stage. Triggering the insolvency process in India [under the Sick Industrial Companies (Special Provisions) Act (SICA) or Companies Act] currently involves judicial judgement. Under IBC, the insolvency resolution process (IRP) can be triggered at the first instance of default, requiring the adjudicating authority to merely confirm the existence of default. This will aid early detection and resolution of stress and also avoid clogging judicial bandwidth at the trigger stage. Also a default only triggers a resolution process, and not liquidation. This is unlike the extant situation where winding up proceedings can be triggered on account of a default of Rs.500, resulting in courts undertaking full hearings at the admission stage and causing delays.

The 180-day timeline is not an implausible one for several reasons. Across the world, firms in distress start conversations about their financial troubles with stakeholders much before initiating formal proceedings. Court-supervised resolution procedures are filed when out-of-court negotiations fail to generate desired outcomes. In the post-IBC regime, if IRP is triggered, it is assumed that the debtor has already undertaken out-of-court negotiations with the stakeholders concerned about possible reorganization avenues to keep the firm as a going concern, and has not arrived at a solution. Triggering IRP is hence considered a last-course effort after sufficient preparation and deliberation.

Once IRP is triggered, it offers a calm period during which a moratorium is imposed on debt recovery actions and existing or new lawsuits against the debtor. During this phase, all creditors come together to collectively assess the viability of the firm and vote on proposed resolution plans, within a well-defined framework of rules enforced by an insolvency professional (IP). The IP takes over management of the firm to prevent potential asset stripping and to continue operations of the firm as a going concern. The likelihood of a moratorium being misused and dilatory tactics applied by promoters is minimal because the debtor loses control. Also there is a credible threat of liquidation should the defined timeframe of 180 days lapse without 75% of the creditors’ committee consenting on a resolution plan.

In view of the above, completing the final round of conversation between the debtor and creditors within 180 days to resolve temporary insolvency as against structural breakdown is not infeasible.

Once the creditors’ committee approves a resolution plan, the adjudicating authority reviews the plan not from a commercial perspective but against touchstones of conformity with applicable laws and repayment of interim finance (on priority) and operational creditors. This will free up judicial bandwidth to focus on critical issues of justice, such as compliance with procedural requirements, overseeing the IP and adjudicating on voidable transactions and potential penalties against management and promoters.

Delays in the resolution process also result from opacity of creditors’ claims and related information. The system of information utilities (IUs) proposed by the IBC and the BLRC report will store all financial transactions between a firm and its financial creditors. This should significantly assist the IP in assessing veracity of claims, thereby saving valuable time.

It is important to underscore here the centrality of the institutional pillars upon which the entire edifice of IBC stands. While the draft bill contains provisions to reduce delays and improve efficiency of resolution, the de facto outcomes in terms of effective and timely functioning of the process are contingent upon building the supporting infrastructure. This includes developing a new class of IPs to conduct the resolution process in a time-bound and disciplined manner, an extensive network of IUs vital for reducing information asymmetry and speeding up the process of initiating IRP and collecting claims, a well-functioning regulator to govern the operations of IPs and IUs as also issuing delegated legislation and finally, an effective adjudicating infrastructure replete with a well-laid-out appeals mechanism.

For the IBC to deliver the desired economic outcome of high recovery rate, a robust implementation plan for building the aforesaid institutions and creating state capacity is essential to complement the enactment of the draft bill. None of these will happen overnight.

It will take time for firms and all stakeholders to get familiar with the new system and to understand the new rules of the game.

From non-performing to performing

Mint, November 25, 2015 (with Richa Roy)

The ministry of finance recently released the draft Insolvency and Bankruptcy Code (IBC), proposed by the Bankruptcy Law Reforms Committee. The government of India greeted this bill as among its biggest and most crucial reforms. To a person unconnected with finance, it may be unclear why this is important or what ails the current framework. A well-functioning insolvency resolution framework is fundamental for dealing with business failures that inevitably occur in any economy. Additionally, an effective insolvency resolution process is one tool, among others, for banks and other creditors to address low recovery rates.

This is particularly relevant for India where economic growth is contingent upon the financial health of the banking sector. Banks in India face acute problems of asset quality. Perceiving that laws did not sufficiently empower secured creditors to activate recovery by seizing security, the Recovery of Debts Due to Banks and Financial Institutions Act, 1993, and Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002, were enacted to facilitate the enforcement of security by banks and financial institutions.

Asset reconstruction companies were constituted under SARFAESI to buy bad debts from banks and recover from defaulters. Domestic banks also have recourse to corporate debt restructuring and joint lenders forum mechanism to resolve stress in consortium loans.

None of these initiatives seems to have helped. Gross non-performing assets (NPAs) as percentage of total advances went up from 3.4% in March 2013 to 4.45% in March 2015. The picture is grimmer when volume of restructured assets is also considered in stressed advances. As a percentage of total advances, overall stressed advances increased from 9.2% to 10.9% between 2013 and 2015. Average recovery rate for secured debt is as low as 20%. One factor responsible for all this is a weak legal framework for resolving failure. Once debts go bad, creditors’ ability to realize value is predicated on a robust insolvency resolution mechanism.

Accumulation of bad debts in bank balance sheets has systemic risk implications for the entire economy. As capital gets tied up in provisioning for bad debts, banks get inhibited from extending fresh credit, slowing down the real sector. Absence of a well-functioning insolvency framework that protects creditors’ rights also thwarts the development of alternative lenders, such as corporate bond market. There are admittedly other issues systemic to the banking system and capital market that compound these problems. However, an insolvency law focused on preserving viable businesses as going concerns and liquidating unviable ones is the cornerstone of a mature financial system and India urgently needs one.

Aparna Ravi highlights in a paper titled The Indian insolvency regime in practice—an analysis of insolvency and debt recovery proceedings that the current framework in India is highly fragmented with decisions frequently stayed or overturned by judicial forums having overlapping jurisdiction. There is no clarity on whether the right of secured creditors initiating recovery under SARFAESI will prevail, or unsecured creditors initiating winding-up under the Companies Act or the company triggering proceedings under the Sick Industrial Companies (Special Provisions) Act, 1985, (SICA).

Substantive issues exist with even initiation of insolvency resolution or the process of winding up. SICA is triggered when more than half a company’s net worth has eroded. In Kristin van Zwieten’s paper titled: Corporate rescue in India: the influence of the courts, she examined over a thousand cases from a range of courts to demonstrate that the Board for Industrial and Financial Reconstruction (BIFR) and the high courts are reluctant to liquidate unviable companies. Ironically, the trigger for winding up a company is too low. The default is Rs.500. Courts, therefore, do a full hearing on merits at admission stage itself, limiting efficacy. Creditors, especially non-banks, do not have access to a mechanism to assess the viability of an enterprise and address the problem, without the threat of other proceedings initiated by the debtor or other creditors torpedoing them. Even when proceedings are triggered, debtor’s existing management retains control, thereby creating the risk of asset stripping.

Under SARFAESI, creditors are empowered to take over management of a company but only that part of the company connected to the secured asset. Since potential liability to creditors is high, this is rarely invoked. There is no corresponding provision for non-banks. There is also no linearity of proceedings. Under SICA, even if BIFR recommends liquidation, a reference is made to the high court, which would re-examine the recommendation and might even reverse it.

With the proposed IBC, the labyrinth of extant Indian laws dealing with corporate insolvency are being replaced by a single comprehensive law that (a) empowers all creditors—secured, unsecured, financial and operational to trigger resolution, (b) enables the resolution process to start at the earliest sign of financial distress, (c) provides a single forum overseeing all insolvency and liquidation proceedings, (d) enables a calm period where other proceedings do not derail existing ones, (e) replaces existing management during insolvency proceedings while keeping the enterprise as a going concern, (f) offers a finite time limit within which debtor’s viability can be assessed and (g) under bankruptcy, lays out a linear liquidation mechanism.

The proposed framework strengthens creditors, without discrimination. While this will not necessarily be a magic bullet that will make the mass of NPAs vanish from bank balance sheets, it can facilitate better recovery and faster closure of troubled assets. IBC will prevent new loans from getting added to existing stock of NPAs. It will aid development of alternative debt securities, spread the risk of corporate failure across larger sets of creditors, and lead to the double benefit of lower systemic risk as well as deeper debt finance for a rapidly growing economy of entrepreneurs.

Bankruptcy reforms: It's not the ranking that matters

Bankruptcy reforms: It's not the ranking that matters The Leap Blog, November 13, 2015.

In defence of the financial code

Mint, July 28, 2015 (with Vivek Dehejia)

The barrage of criticism of the proposed draft of the Indian financial code (IFC) released by the finance ministry last Thursday has, unfortunately, contained more heat than light, with ill-informed criticisms being passed off as accepted wisdom.

What has attracted the greatest ire of critics is the proposed seven-member monetary policy committee (MPC), which will be charged with setting policy rates to ensure that the inflation-targeting mandate, already enshrined in the monetary policy framework agreement between the Reserve Bank of India (RBI) and the finance ministry, is fulfilled.

Recall that the MPC would replace the current system in which the RBI governor effectively has absolute power to set policy and is not bound by recommendations of the technical advisory committee.

The most often repeated criticism is that, because four of seven members of the MPC will be appointed by the finance ministry, while only three will be internal to RBI, including the governor as chairperson, somehow the independence of RBI will be lost. Those who have been chanting this as mantra appear to be unaware of the fact that RBI at present lacks any form of statutory independence.

Under the RBI Act, 1934, an antiquated law that still governs the central bank, the 21 members of the central board of directors are all, directly or indirectly, appointed by the Union government, including and most notably the governor himself. Under existing law, the government may dictate policy to RBI, which the governor will be obliged to obey. Thus, in reality, any putative independence the RBI may currently enjoy depends entirely on the strength of character of the governor to resist political pressure. This is hardly a template for good governance and leaves good monetary policy to chance.

By contrast, under the proposed new system, the MPC—critically operating not with carte blanche but charged with ensuring that the inflation target is met—will bear collective responsibility for monetary policy conduct, and its individual members, including the governor, will therefore be shielded from political interference more than in the current single decision-maker scenario.

It is harder to pressure and influence a committee of several members as opposed to influencing only one person. It is a specious and illogical argument to suggest that its functioning will be impaired merely because a majority of its members are appointed by the government—when the current arrangement creates a far greater danger that the government could browbeat the governor into doing its bidding.

Also, an MPC formed with non-RBI members, appointed from various walks of life, will bring with it diversity of opinion and plurality of ideas, whereas internal RBI members are more likely to share similar views. Further, unlike the current arrangement in which the governor is not obliged to explain the rationale for a policy decision—although, in practice, he generally does—the new system will require each member to furnish a written explanation for his/her vote on any proposed resolution, and minutes of MPC meetings will be made available for public scrutiny.

This creates far greater transparency in monetary policy conduct than our current system, in which decisions are shrouded in secrecy and in which, therefore, there is considerable leeway for the governor to act with discretion. A basic tenet of modern theory and practice of central banking is that a system which is opaque and allows discretion will invariably deliver worse outcomes than a transparent and rule-governed system, which the MPC plus the inflation targeting regime will provide.

What is more, given that the MPC will not operate in a policy vacuum, but explicitly to achieve the 4% inflation target, with a tolerance band of 2% around it, there is automatically an accountability mechanism built into the system. The public, investors or anyone else can observe whether the MPC is doing its job or not.

Each member’s personal reputation will be on the line every time he/she proposes an action that ends up jeopardizing the inflation-targeting mandate. An MPC, which repeatedly fails to meet the inflation target, will lack credibility, and this is something no government would wish to happen. In a globalized capital market, the cost of an erratic and uncertain monetary policy, with attendant volatility in interest rates and exchange rates, would be damaging economically, and therefore politically.

It could be countered, if the mandate of the MPC will ensure accountability, then why not let RBI hold a majority on the MPC? The reason is that an RBI-dominated MPC will, inevitably, be an MPC dominated by the governor himself. Junior colleagues of the governor who sit on the MPC would almost surely be reluctant to disagree with him and end up voting with him—whether because of group think, or simply due to power imbalance.

In other words, the presence of four external members is, in fact, a check on an MPC, which otherwise might be dominated by the governor, and therefore, would not be very different from the current system in which the governor is all-powerful.

The bottom line is that our current arrangement is really a non-system that functions well only if a wise and sagacious individual is in the chair. What we need is to hard-code best practice and institutionalize it, and this is exactly what the IFC, including the MPC, proposes.

The nuances of inflation targeting in India

The nuances of inflation targeting in India Ideas for India, March 16, 2015 (with Abhijit Sen Gupta).