RBI's alternative route for foreign debt inflows

RBI's alternative route for foreign debt inflows, The Leap Blog, November 6, 2018 (with Radhika Pandey and Bhargavi Zaveri).

An annotated reading list on the Indian bankruptcy reform, 2018

An annotated reading list on the Indian bankruptcy reform, 2018, The Leap Blog, August 14, 2018 (with Anjali Sharma).

The proper purpose of insolvency law

Mint, May 6, 2018, (with Pratik Datta)

When a company becomes insolvent, numerous issues arise. Insolvency law is meant to address some of them, but not all. For the others, the solution must be found in non-insolvency laws. This distinction has been overlooked by Indian policymakers in their attempts to reform the Insolvency and Bankruptcy Code, 2016 (IBC). The recently submitted report of the insolvency law committee (ILC) also reflects this oversight. This may hamper the desired outcomes of the IBC.

The ‘proper’ purpose

In the absence of an insolvency law, if a company defaults on a loan to a creditor (i.e. becomes cash flow insolvent), every claimant would have to race to grab its share of the company’s assets. This fight among its claimants could push the company into liquidation even if it has an otherwise sound business model. This would lead to unnecessary destruction of the company’s organisational value and cause job losses.

From the creditors’ perspective, the winner-grabs-it-all situation would make the business of extending credit more risky. Moreover, a company’s shareholders are the residual claimants with limited liability. When the company approaches insolvency, they have every incentive to engage in high-risk strategies. If the strategy works, they gain from the upside. If the strategy fails, it is the creditors who lose. Shareholders could also engage in asset siphoning and related party transactions. These risks would be aggravated if the incentives of shareholders and managers are aligned. Creditors would price in all these risks ex ante and lend at higher interest rates, hurting borrowers. Overall, the economy would be worse off.

A well-defined insolvency law helps avoid these problems. Therefore, the "proper" purpose of such a law would be to provide:

1. a collective procedure for insolvency resolution, and
2. rules to control the opportunistic behaviour of shareholders and managers in the vicinity of insolvency.

Examined from this perspective, the recent changes made to the IBC as well as some of the recommendations of the ILC report go far beyond the proper purpose of insolvency law. They are an attempt to solve the problems surrounding IBC stakeholders that are better solved outside the IBC.

Promoter disqualification

Let us consider the question of who should be disqualified from controlling an insolvent company. This is an important issue which should be addressed through corporate law and not through insolvency law. A person who is disqualified from controlling an insolvent company, should also be disqualified from controlling a solvent company. There is no reason to have a different disqualification regime for insolvent companies.

To illustrate, currently, under section 29A of the IBC, a person who is declared a wilful defaulter by the Reserve Bank of India (RBI) or is prohibited from trading by the Securities and Exchange Board of India is not eligible to bid for an insolvent company. Yet, the same person is qualified to be a director of companies under section 164 of the Companies Act, 2013. In other words, a person who cannot be trusted with the control of an insolvent company is trusted with the control of a healthy company. This is an anomaly.

If policymakers want to keep undesirable persons out of the boardrooms of companies, they should upgrade the directors’ disqualification regime under the Companies Act. For instance, if a company is declared a wilful defaulter by the RBI, the directors of such a company should be disqualified from being company directors under the Companies Act. This would ensure that a wilful defaulter cannot directly or indirectly control any company, including the insolvent business. This being a corporate law issue, there was no need to create a complex promoter disqualification mechanism for insolvent companies under the IBC.

Homebuyers as ‘financial creditors’

A time-honoured principle in insolvency law is that it should respect non-insolvency entitlements such as security interests. Put differently, the job of an insolvency law is to maximise the size of the pie, not to distort the distribution of the pie under non-insolvency laws. The ILC’s suggestion that homebuyers are "financial creditors" violates this fundamental principle.

To illustrate, secured creditors have higher entitlements than unsecured creditors (like homebuyers) in non-insolvency law. If the insolvency law prejudices such entitlements of secured creditors, they would engage in strategic behaviour to opt out of collective insolvency proceedings. They could realise the collateral earlier than would be collectively optimal, so as to beat unsecured creditors in the race to grab assets. Even if the law successfully curbs any such strategic behaviour by secured creditors, they will adjust and increase the interest rate of secured credit. Either way, this will defeat the ultimate objective of the insolvency law, which is to reduce the cost of borrowing.

Homebuyers’ rights need to be protected but there are good and bad ways of doing do. Using the IBC to protect their interests is the bad way. They could have been better protected through non-insolvency laws. For example, the UK Law Commission, in a 2016 report, suggested a range of non-insolvency law mechanisms (like trusts, insurance, digital payment laws) to protect consumer prepayments on retailer insolvency. In contrast, the ILC assumed that since the homebuyers’ problem arose during insolvency, the solution to it must lie in the insolvency law.

Indian policymakers need to recognise the proper purpose of the insolvency law. The IBC must be used only to address those purposes. For all other purposes, the solution must be found in non-insolvency laws.

PSU bank privatization is not a panacea for the ills of the banking sector

Mint, March 22, 2018 (with Shubho Roy)

The PNB fraud has rekindled the debate on bank privatization, often considered a solution for the poor management in public sector banks (). While government ownership of businesses is a bad idea and leads to poor economic outcomes, we should not pin all hopes on privatization as a solution. It is not a panacea for the ills of the banking sector unless accompanied by reforms in banking regulation.

The Reserve Bank of India (RBI) has often cited government ownership as an explanation for management failures in PSU banks. The RBI committee to look into the governance of PSU banks in 2014 stated: “If the Government stake in these banks were to reduce to less than 50 per cent, together with certain other executive measures taken, all these external constraints would disappear.” There are incentive conflicts when government owns banks, and this affects the efficiency of capital allocation. However, this does not explain why the RBI cannot hold the PSU banks accountable for issues such as capital adequacy, fraud control or appropriate reporting of financial statements.

RBI’s powers over PSU banks

It is true that the RBI does not have all the powers over PSU banks that it has over private sector banks, such as the power to revoke a banking licence, merge a bank, shut down a bank, or penalize the board of directors. However, Section 51 of the Banking Regulation Act, 1949 enables the RBI to exercise some powers over PSU banks, which apply notwithstanding any special provision governing PSU banks in other laws.

The RBI can control the lending policy of PSU banks, including determining maximum exposure, and the purpose of lending (Section 21). The RBI approves the auditor for PSU banks and has the power to issue special audits on PSU banks (section 30). RBI can lay down the returns that a PSU bank has to file (Section 31). RBI can inspect PSU banks just like private sector banks (Section 35), and give directions, including directions on management (Section 35A). It can appoint RBI officers to attend board meetings of PSU banks and speak in them, collect all communications of a PSU bank’s board, and require PSU banks to make changes in management (except board) (Section 36). RBI can ask PSU banks to maintain records as per rules made by RBI (Section 45Y), impose penalties on PSU banks through the courts (section 46) or directly under RBI systems (Section 47A). RBI cannot impose penalties on PSU bank directors appointed by it or the government. But this protection does not extend to other employees of the banks.

The lack of some powers of RBI over PSU banks is balanced, to some extent, by the right of RBI to appoint a director on the board of a PSU bank (bank nationalisation laws and the law governing State Bank of India). Unlike private sector banks, this director must have expertise and experience in regulation and supervision of banks, a skill available only with RBI. This allows the RBI to keep a PSU bank under constant supervision.

Regulation of private sector banks by RBI

Had government ownership been a constraint for effective banking regulation, we should have seen better oversight of private sector banks. That has not always been the case. For instance, in recent times, we have come to know about the divergence between the non-performing assets (NPAs) stated by major private sector banks in their regulatory disclosures and the amounts that the RBI uncovered during its inspections. RBI found that Yes Bank’s NPAs were 558% more than reported. Similar divergences have been found in Axis Bank and ICICI Bank. Although the bulk of the NPAs are in PSU banks, the private sector banks are not fine either.

We know from media reports that RBI fined Yes Bank and Axis Bank for these divergences. However, the information on penalties is not publicly available on RBI’s website. We do not know whether due process was followed before imposing sanctions on these banks, whether the fines were backed by a show cause notice, and a reasoned order. We also do not know whether any other bank reporting NPA divergences has been fined. The lack of transparency in the manner in which banking regulation is enforced applies to all banks irrespective of the ownership structure.

Private and public sector banks are driven by different incentives which may help explain the difference in the violations seen in these two categories of banks. In the private sector, the shareholders’ effective control over banks may explain the absence of large-scale frauds such as the PNB episode. However, the interests of shareholders may not be aligned with those of the regulator.

In banking, shareholders bring only Rs12 of every Rs100 of the capital required to do business. The rest is brought in by depositors. Shareholders are interested in trying to get their return as quickly as possible and hide the bad news. When banks fail, shareholders have already recouped their investments and depositors are left high and dry. Prudential regulations, such as NPA norms, are designed to prevent this.

NPA regulations require banks to keep money stowed away to repay depositors. This is done by reducing the income of the bank by the amount of NPAs. Lower NPAs mean there is more profit to be distributed as dividends to shareholders. So, the shareholders and the management of private sector banks have interest in showing lower NPAs. It is the job of the banking regulator to prevent this from happening. When a bank understates its NPAs, it is a failure of banking regulation.

For a long time, banks had access to restructuring schemes (such as corporate debt restructuring, strategic debt restructuring and schemes for sustainable structuring of stressed assets,) initiated by RBI. Both private and public sector banks used these schemes to delay the recognition of bad loans. While in a welcome move, the RBI has now withdrawn these schemes, the fact remains that they played a big role in worsening the current NPA crisis.

Income and loss recognition continues to involve discretion from the regulator. PNB has asked RBI to spread out loss provisioning from the recent fraud over four quarters. This is in spite of RBI regulations requiring fraud to be recognised and provisioned for immediately. PNB has good reasons to expect a special dispensation from RBI, which will allow it to violate RBI’s regulations. Such exceptions are frequently made. For example, in May 2015, the RBI allowed lenders to keep loans to Haldia Petrochemicals as standard assets, even though they had been restructured twice and should have been designated as NPAs.

Regulation of private sector banks: Misselling

Failure in regulation is not limited to prudential regulation. On several occasions, RBI has not been able to protect the interests of consumers and the problem may be systemic. Monika Halan (consulting editor, Mint) and Renuka Sane show in an academic paper, "Misled And Mis-sold:Financial Misbehaviour In Retail Banks" that there is widespread misselling in both private and public sector banks. Banks rarely disclose the features of their products and frequently provide incomplete or inaccurate information. The situation became so bad in Rajasthan in a misselling episode involving ICICI Bank that the police had to step in.

While the underlying financial products in such misselling may be regulated by the Securities and Exchange Board of India or Insurance Regulatory and Development Authority of India, the act of misselling takes place in banks, which are regulated by RBI. All financial regulations are for (1) consumer protection (2) micro-prudential oversight (3) resolution and (4) systemic risk reduction. When bank officers cheat consumers, this violates consumer protection and falls within the purview of banking regulation. The fact that misselling is rampant in private sector banks goes to show that there are problems in these banks too.

Banks can earn more fees and make higher profits by selling financial products with high commissions, as opposed to the appropriate financial products, to consumers. If the management of a private sector bank is incentivised to increase income, they will try to sell insurance products (which may carry commissions equalling the entire premium for one year) rather than fixed deposits (the Rajasthan episode).

The objective of banking regulation is to make the management of banks, both private and public, take decisions which they would not normally take to protect depositors and consumers. Since the incentive structures of the management of private and public sector banks are different, they will take different types of decisions. But in both cases, the decisions may adversely affect the consumers and the depositors.

Privatization of banks, with the same level of regulatory capacity and the same quality of regulatory oversight, may only trade one type of banking management failure (frauds, poor system controls) with other types of failures (underreporting of NPAs, misselling of financial products). There is no evidence that the RBI is better at regulating private sector banks and no reason to believe that bank privatization will cure the ills of banking regulation.

Doing the right thing for the wrong reasons is dangerous. Privatisation may solve other problems in the economy, free up fiscal resources and may even reduce corruption, but it is not a solution for regulatory weaknesses. If bank privatisation is the only reform that is undertaken in response to the current crisis in the banking system without fixing fundamental problems in banking regulation, the crisis will keep recurring. This will then delegitimise the privatisation move. The consequent backlash may undo many good reforms which have reduced the role of state in commerce and redirected it towards public goods like regulation.

PNB scam: RBI should regulate using legal, coercive powers and not through requests, entreaties

Firstpost, March 5, 2018 (with Shubho Roy)

The recent fraud at Punjab National Bank (PNB) highlights the lacunae in banking regulation and its enforcement. As the banking regulator, the Reserve Bank of India has been vested with powers of the State through acts of Parliament to discharge certain duties. It can not only advise or issue warnings to banks, but also has coercive power over banks. It can use its coercive powers through formal, legal means to ensure that an individual episode like the PNB or an overall collapse of the banking system does not take place. If the RBI continues to fail at regulating banks, is it time for a system overhaul?

A regulator writes subordinate legislation in the form of regulations and enforces the same. Apart from legislative power, it also has executive and quasi-judicial authority over the regulated entities. The RBI drafts regulations and it has the power to conduct investigations such that the regulations are effectively implemented. When the regulated entities, in this case banks, violate the regulations, RBI has the power to punish them. That is the job of a regulator and that is how a regulated system operates. This is so designed in order to prevent market failures.

Sound banking is the RBI’s responsibility. Despite there being a banking regulator, India’s banking system gets mired in one crisis after another. Among other factors, lacklustre enforcement of regulations has resulted in a prolonged collapse of the Indian banking system. This brings us to the question as to why the RBI performs poorly as a banking regulator? One of the reasons for its failure is the poorly designed process of making regulations and enforcing them.

Regulators in countries where rule of law prevails are supposed to use legal instruments to discharge their duties. This places an obligation on the regulated to comply with the instructions. It also protects the rights of the regulated because they can challenge such instructions in the appropriate court of law. For example, a speech in Parliament does not become a law. It has to be introduced as a Bill, passed by a majority of legislators, and then receive the assent of the President. Only then are citizens expected to comply with them. This ensures that the checks, balances and formality of a legal system are maintained. Legal systems ensure that there are consequences for violation as they usually provide penalties for non-compliance.

While the laws empower RBI to adopt formal, legal means to establish rules and enforce them, the RBI often uses informal means. This dilutes the sanctity of the regulatory process with the regulated entities picking and choosing what to comply with, depending on the situation at hand. Use of informal and extra-legal means to exercise powers come in the way of effective enforcement of banking regulation.

For example, in the aftermath of the PNB episode, RBI has now directed banks to connect their core-banking systems (CBS) to the SWIFT system by 30 April. This is the second such informal communication between the regulator, and the regulated. The RBI claims it had previously warned banks through letters and speeches about the problems in SWIFT.

Back in 2015, Union Bank had a similar problem regarding the reconciliation of SWIFT and CBS systems and a deputy governor of the RBI mentioned this in a speech. The RBI did not issue any mandate to the banks to compulsorily implement this reconciliation. There is no explanation as to why the RBI did not use its coercive powers through formal, legal means in 2015 to bring about this change in the banking system.

The RBI has powers under the Banking Regulation Act, 1949 (Section 35A) to give directions to banks. Violations of such directions are punishable by monetary fines imposed on the bank and officers responsible for the violation. The RBI frequently uses this power to issue formal directions. For example, on 12 February, the RBI published formal directions on the resolution of stressed assets. The directions clearly stated the legal authority under which the RBI was issuing them and were publicly available. Any bank violating these directions can now be penalised under the law.

On the contrary, for the instructions on connecting SWIFT to CBS, we have to depend on second-hand information. The RBI has not provided any update on its website. It is not clear if any legal instrument has been used to enforce the 30 April deadline. What happens if a bank does not comply with the 30 April deadline? Will penalties be imposed? Will there be any consequence? We do not know.

Correcting this anomaly requires two steps. First, the RBI and all other regulators adopting a similar approach, need to rework their internal systems in order to cease using informal methods of regulation. This can be done without any changes to the existing regulations.

Regulatory work should be carried out using powers bestowed upon the regulator in legislation, using processes and systems mandated in the legislation. Second, the legislation governing regulators, should be reworked to bring in a modern regulation-making system which involves identification of market failures, a cost-benefit analysis of the intervention, invitation of public comments, regulatory response to comments, and oversight of the Parliament.

Violation of regulations should always be punished by proportional penalties once an adjudication process has taken place and should be reported to the public.

The draft Indian Financial Code as recommended by the Financial Sector Legislative Reforms Commission, embodies these principles. A legislative change is not needed for the regulators, including the RBI, to voluntarily adopt these recommendations. The Department of Economic Affairs in late 2013 had formulated a handbook to help all regulators implement such Governance Enhancing Recommendations of FSLRC. In 2014, all the financial sector regulators had agreed to implement these recommendations.

The change in the internal processes of the regulators, including the RBI, has been slow. An overhaul of the process of issuing and enforcing regulations to better discipline the banks is the need of the hour if recurrent crises in the banking sector are to be prevented.

Communicating uncertainties in GDP data

Communicating uncertainties in GDP data, Ideas for India, February 19, 2018 (with Amey Sapre).

Bank recapitalisation: the allocation challenge

Bank recapitalisation: the allocation challenge, The Leap Blog, January 30, 2018 (with Anjali Sharma).