On defaulters, RBI prioritises public interest

Indian Express June 20, 2023

On June 8, 2023 the Reserve Bank of India set out a framework for bank settlements with defaulters. This circular has triggered widespread criticism because it covers settlements with fraudulent and wilful defaulters implying to some that the RBI is condoning their crimes. This interpretation is not correct. On the contrary, the point of the circular is to establish safeguards so that public interest is protected when banks make such settlements. That said the circular has once again brought to fore two deeper issues in the Indian banking system: government ownership of banks and weaknesses in regulatory governance.

Let's first understand why this issue has even arisen. Why should banks settle with defaulters?

When there is a default, the primary objective of a bank is to recover as much of the loan as possible. Various options might be available to the bank for recovering the loan. The bank decides which strategy would work best, based purely on commercial judgement. For instance, the bank may want to trigger the Insolvency and Bankruptcy Code (IBC, 2016) against the borrower. Alternatively, in some cases, the bank may decide to pursue a “compromise settlement” wherein the bank and the borrower negotiate a settlement amount. It is wrong to think that the RBI has permitted something unusual. One-time settlements are part and parcel of the business of banking. The RBI has simply given a formal regulatory structure to a standard banking practice.

Some of these settlements can indeed be with wilful and fraudulent defaulters. When trying to recover a loan, a bank should not make any distinction between whether the default is wilful, fraudulent or otherwise. Irrespective of the nature of the default, it is upto the bank to decide whether a settlement is a better and quicker option instead of triggering the IBC or pursuing some other strategy. The sole motivation behind such a decision should be to maximize recovery, as speedily as possible. This will help unlock banking capital that is stuck in the wilful default or fraud categories.

What about the crimes that these defaulters may have committed?

The RBI circular makes it clear that banks should feel free to file cases against fraudulent or wilful defaulters. It explicitly states that banks will undertake settlements “without prejudice to the criminal proceeding underway against such debtors.” This separates the criminality of a particular default case from the commercial aspect of it. In other words, no, the circular does not condone any crimes. But the pursuit of a criminal action against a defaulter should not necessitate suspending commercial judgement. This distinction is vital.

That said, there are some valid concerns. One apprehension stems from the government control over the boards of public sector banks. This creates a risk that the settlement process might be misused to favour politically connected defaulters at the cost of the banks’ commercial interests. This concern may not be wholly without merits, and it is therefore incumbent upon the RBI to allow the commercially prudent decisions and prevent the politically motivated ones. Only time will tell whether the requirements and safeguards laid down by the circular will be sufficient for this purpose.

In addition, there are some broader issues that need to be highlighted.

There is ample anecdotal evidence that private sector banks have been settling with wilful defaulters for a while now. So, if banks have already been doing such settlements and various instructions to this effect have already been issued by the RBI to banks over the years, then one might ask: what was the need for this circular?

The answer possibly lies in the fact that two-thirds of the Indian banking system is owned by the government and public sector banks are more likely to come under the scrutiny of investigative agencies for any action they take. The RBI circular gives these banks the regulatory cover for settlement related decisions. In a narrow sense therefore the circular merely levels the playing field. But from a wider perspective, the fact that a circular needed to be issued underscores the distortions that the Indian banking system suffers from owing to the government ownership of banks. In a fully privately-owned banking system there would be no need for such a circular and the ensuing controversy could have been avoided.

The second broad issue concerns regulatory governance. A year ago, the RBI's Regulations Review Authority 2.0 recommended that the RBI place all draft instructions on its website for stakeholder comments and finalise them after considering the feedback. Exceptions should be made only in special circumstances. There do not appear to have been any special circumstances surrounding the June 8 circular. There were no issues related to financial stability, or fiduciary duty, or confidentiality. There does not even appear to have been any pressing urgency. At the same time, the circular is of great public interest since it applies to entities against whom criminal proceedings are underway.

Hence, the draft circular could and should have been placed on the RBI’s website for public consultation along with a discussion paper clearly explaining its rationale. Concerned stakeholders could have expressed their concerns and the RBI would have had the opportunity to assuage their misgivings by making suitable clarifications to the draft circular before notifying it. That would have saved much trouble for both the central bank and the government.

Banks are commercial enterprises and should be allowed to operate accordingly. In principle, separating a commercial decision such as loan recovery from criminal proceedings against wilful defaulters is a step in the right direction. However the situation in India is unduly complicated because of government ownership of commercial enterprises and gaps in regulatory governance. Future public discourse should focus on these fundamental problems, and not on how banks or RBI could play the role of moral police.

The post-pandemic credit landscape in India

The post-pandemic credit landscape in India, Ideas for India, May 8, 2023.

Should monetary policy be used to target financial stability?

Mint, April 2, 2023 (with Harsh Vardhan)

The recent financial market turmoil in the US triggered by the collapse of the Silicon Valley Bank has raised questions about the impact of the US Fed’s monetary policy on the stability of the banking system. More generally it has brought back to fore a fundamental question that central banks all over the world have been grappling with for a while now – should financial stability be given priority over inflation in the conduct of monetary policy? There is no easy answer to this as both problems are serious.

This issue is of crucial importance for India as well. It has been less than a decade since the Reserve Bank of India adopted inflation targeting as its monetary policy framework and under IT, the primary goal of monetary policy is achieving price stability. Expecting monetary policy to also keep an eye on financial stability, will distract attention from the central bank’s legally mandated objective, and may lead to destabilising outcomes for the economy in general.

There are some practical as well as conceptual problems in making financial stability an objective of monetary policy.

First of all, it is difficult to define financial stability. We can only see financial sector instability when it manifests for example through the failure of a systemically important bank, or the bursting of an asset price bubble, but before such an event occurs, we cannot precisely describe what is financial sector stability. Moreover, there are various institutions in the financial system involving a large number of participants that interact with each other thereby creating a complex, interconnected network. Within this system, sources of financial instability can be varied. We have seen financial instability occurring due to failures of banks, insurance companies, pension funds or mutual funds, and we have seen crises in the stock market and bond market. Ex-ante, it is often difficult to identify the specific part of this vast, complex network where a risk is building up.

Also, once instability occurs in any part of this network, given the interconnectedness, it can spread through the entire system leading to what is commonly known as contagion. It is difficult to predict whether an event of financial instability will indeed trigger a contagion, how rapidly the contagion will spread through the system or what impact it will have on different parts of the network.

Secondly, given that financial stability is difficult to define, it is also hard to measure. Often financial sector regulators use "stress tests" to assess the resilience of the system under various scenarios. Problem is that they only test for risks that they are worried about. There are many other risks beyond the obvious ones and typically those are the ones that get financial institutions into trouble, all the more making financial stability difficult to measure.

Monetary policy works best when it has clearly defined objectives and quantitative targets that guide its formulation. Given the challenges of defining and measuring, it is difficult for monetary policy to target financial stability as compared to price stability which can be both defined as well as measured. In India, for example, the IT framework clearly lays out the goal of the RBI’s monetary policy as achieving a 4% CPI (consumer price index) target. Such a clear, quantitative target is inconceivable when it comes to financial stability.

Finally, and most importantly, policymaking must be guided by the Tinbergen principle which conceives of economic policy as the relation between instruments and goals. It stipulates that the number of achievable goals is limited by the number of available policy instruments. Under the inflation targeting framework, the repo rate in India (or the Fed funds rate in the US) must be used to target inflation. It is therefore best to find another tool to address financial stability so that the Tinbergen principle can be applied.

So if monetary policy is not the answer, then what can be done to address financial instability?

Some have argued that central banks can inject liquidity to safeguard financial instability. There are three problems with this. First, injecting liquidity only makes sense when the underlying problem is illiquidity, say an irrational run against a bank with safe but illiquid assets (such as a loan to a profitable factory). But this is hardly ever the case. Usually, as in the case of SVB, runs occur because banks are insolvent i.e. the value of their assets has fallen below the value of their liabilities. In such a situation, the only solution is to inject capital. Injecting liquidity can in fact make matters worse because it enables more people to flee the ailing bank(s), thereby increasing -- not reducing – panic.

Secondly, liquidity can be a temporary solution in situations involving a credit freeze and, it may help restore confidence in the system. But it is like calling the fire brigade in the event of a fire; it is needed to douse the fire but does not help prevent future fires.

Third, addressing instability using liquidity may also mean keeping the system flooded with excess liquidity for a long time which in turn may endanger price stability.

Broad based financial stability can be achieved only by improving governance standards, and establishing strong supervisory oversight over the concerned institutions to help avoid the build-up of risks. The SVB collapse, like the Global Financial Crisis of 2008, reflected a colossal failure of governance and supervision.

In summary, in the short run, the solution to financial instability is capital; in the long run, it is better governance and supervision. Monetary policy would then be free to pursue its "natural target": price stability.

In the case of India on the other hand, price stability is a pressing concern. CPI inflation has been higher than the RBI's target level of 4% for a while now and in particular, core inflation has been remarkably stubborn at 6% for a long period of time. Hence, as the RBI gears up to announce its monetary policy decision on April 6, it needs to retain its focus on lowering the CPI inflation to the target level. The US Fed may have slowed down the pace of rate hikes in view of the latest financial market turmoil but that should not distract the RBI from prioritising domestic macroeconomic stability and inflation control.

3 potential problems for India's economy

Times of India, March 21, 2023

If 2022 was the year of “heightened global uncertainty”, this year is proving to be no different. Until last week, the US financial system seemed resilient to the aggressive interest rate hikes of the Federal Reserve. That perception has now been shattered. With the collapse of as many as three banks, including the Silicon Valley Bank (SVB) which was the 16th largest bank in the country, cracks have started showing in the US banking system, triggering fears of a possible financial contagion. The macroeconomic repercussions will be felt far away in India, even if our banking system does not immediately face the same kind of problems. How might the US situation play out, and what does it imply for the Indian economy?

The genesis of the SVB episode can be traced to the decisions of the US Federal Reserve during the pandemic period. The Fed lowered interest rates close to zero and injected vast amounts of liquidity. Banks consequently received large volumes of deposits and, invested them in treasury bonds. This meant that many banks, like SVB, whose loans books are much smaller in comparison to their deposits, became dependent on the treasury bonds for earning returns.

This became a problem when the Fed started aggressively raising rates in 2022 in its fight against inflation. As interest rates go up, bond prices fall. As a result, SVB began incurring losses on its bond portfolio. Sensing problems, depositors began withdrawing money from SVB—a classic case of a bank run, which led to its eventual collapse.

The problem, however, is far broader than just SVB. Any bank which has a smaller loan book, a bigger deposit base, and a large portfolio of treasury bonds now faces similar risk. In fact, US banks are currently sitting on an estimated $600 billion in potential losses owing to the erosion of their bond portfolios, on a capital base of $2 trillion. In other words, interest rate risk has eroded about 30 percent of the capital base. Within this aggregate, the distribution varies considerably, with midsize banks facing significantly higher capital erosion, which is why they have been facing runs in recent days.

This has put the Fed on the horns of a dilemma. If it sticks to its current strategy of raising interest rates to curtail inflation, bond losses will only increase, putting more stress on vulnerable banks. Alternatively, the Fed could pause or even start reducing rates, thereby relieving the stress on the banks, but at the cost of worsening the inflation problem. In other words, the important question for the US economy now is: will growing concerns of financial stability deter the Fed from pursuing its goal of price stability?

Irrespective of what the Fed decides, there will still be difficulties for India.

In particular, investors will remain very cautious, and will continue to doubt the financial stability of the midsize US banks – as we have seen over the past week. Things may get even more complicated if there are bank failures in the European Union. EU banks are vulnerable to similar risks given that the ECB has been tightening monetary policy as well. Already, fears of a contagion were running high when Credit Suisse, one of the systemically important banks at a global level, began witnessing rapid fall in its share prices last week. This eventually led to a takeover of the bank by rival UBS, a move orchestrated to calm the financial markets.

Any further bank failure could trigger a system-wide panic, and push depositors away from smaller banks to bigger, more diversified banks thereby precipitating more bank-runs. The resultant uncertainty would lead to heightened risk aversion.

In such an environment of risk aversion, there is typically a flight to safety. This will have important implications for India. There will be a surge in demand for “safe” assets such as gold etc., while the currencies of emerging economies like the Indian rupee will come under pressure as foreign investors flee these markets. The rupee has depreciated a fair bit in the last one year and, this trend may continue.

In addition, risk aversion is likely to dampen sentiments in the US, at a time when concerns about an impending slowdown have already persisted for a while. This may lead to a decline in credit growth and hence consumption, given that a large part of the US consumption is credit-fueled. Simply put, financial market turmoil might cause people to hold back spending. If this takes too severe a shape, then the US economy could fall into a recession, thereby hampering India’s growth prospects through the exports channel. Exports bailed out the Indian economy during the pandemic, but they have now stopped growing and, the situation is likely to worsen if the US goes into a recession.

Finally, if the Fed abandons its fight against inflation, this too will be problematic for India because we end up importing high inflation from the countries we trade with. This would aggravate domestic inflation, at a time when it is already running at 6.5 percent, well above the Reserve Bank of India’s 4 percent target.

The Indian economy has experienced a stuttering recovery from the pandemic. Its medium- term growth outlook remains weak, because private investment continues to be sluggish, exports are declining, consumption demand is lackluster and, the fiscal situation is overstretched. Now, the shockwaves from the banking crisis in the developed world are likely to create further headwinds for India’s growth.

We should consequently gear up for another year of volatility, amidst growing global uncertainty.

SVB crisis has brought the trade-off between price stability and financial stability back into focus

(with Harsh Vardhan), MoneyControl, March 17, 2023

Just as it seemed the world had come to terms with a certain level of uncertainty that was triggered last year by the US Fed tightening monetary policy, the Russia-Ukraine war and the Covid resurgence in China, a new source of uncertainty sprang up over the last few days—financial stability concerns in the US economy as manifested through the collapse of the Silicon Valley Bank (SVB). The shock reverberated through the US stock market with shares of several banks plunging. Some European banks have begun experiencing steep losses in share prices as well. For India, the relevant questions are: can something like this happen here, and what lessons can we learn from this saga?

Several analysts and commentators in India have written extensively about this episode. The general consensus seems to be that, thanks to the business model of Indian banks, the regulatory oversight of the RBI, relatively gradual monetary tightening in India compared to the US, and careful management of the yield curve by the RBI, an event like this is unlikely to occur in Indian banking.

While that may be true, this episode nonetheless offers some important lessons for Indian banking and its regulation.

Market risk in banks: This episode is a rare one where a bank collapsed due to market risk and not credit risk i.e. not due to a rise in non-performing loans, something we have witnessed frequently in India. The total marked to market losses that US banks are currently sitting on owing to the fall in the value of the government bonds in their portfolios, are estimated to be $600 billion on a capital base of $2 trillion, thereby implying that market risk has eroded about 30% of the capital base of US banks. Generally, In India we do not pay adequate attention to market risk in banks. But banks are steadily increasing their holding of bonds (see here: https://www.moneycontrol.com/news/opinion/why-banks-are-buying-more-bonds-6139661.html) which enhances their exposure to market risk. It is high time we started looking at this risk carefully.

Swift resolution: It was remarkable to see the speed with which the authorities acted to resolve the SVB crisis. Within a matter of days, the Fed and the FDIC (Federal Deposit Insurance Corporation) stepped in, evaluated the situation, and reopened the bank under a modified name. The bank is now being auctioned off and will be sold shortly. FDIC also publicly announced that they would bail out all the depositors.

Quick action is critical in the resolution of financial entities to restore public confidence, and prevent a contagion. It requires clearly laid-out laws, and protocols and also institutions empowered to implement them. Else, each resolution is dealt with on a sui generis basis and could lead to inefficient outcomes as is often the case in India. While we now have a bankruptcy law for non-financial companies, we do not yet have a well-defined law for resolution of financial entities. It is also important to note that the FDIC followed the expected pecking order of loss absorptions – they wiped out equity holders, followed by bond holders and saved the depositors. Contrast this with the Yes Bank resolution in India where AT1 bond-holders were written down before equity.

Moral hazard: One action taken by the FDIC however may offer lesson of what not to do. They announced that they would bail out not only the 7% secured depositors, but also the uninsured depositors.

In case of a bank failure, deposit insurance is meant to safeguard the deposits of small investors. Large depositors whose deposits are beyond the threshold stipulated in the deposit insurance schemes ($2,50,000 in the case of SVB) are expected to be “informed” depositors who should take into account the robustness of the bank before making a deposit. Such depositors are expected to bear the risk of the bank defaulting. Bailing out these depositors as if they were insured, creates a “moral hazard” problem. It creates expectations among the uninsured depositors of similar institutions that they too will be bailed out if such a situation arises. It generates an illusion of implicit government guarantee for all depositors.

Age of social media: As the depositors started shifting out of the bank, SVB had to sell some of its bonds to repay them, but in doing so it incurred losses since the bonds had lost value with rising interest rates. The size of this loss and the potential for future losses in relation to its capital doomed the bank and created the perfect recipe for a “bank run”. Once panic spread in social media about the bank’s stability, this ensured that the run happened very quickly, before the bank or the authorities had any time to react. Some commentators have rightly called it a “Twitter” driven collapse. This exposes the vulnerability of banks to such attacks in the era of social media.

Over and above these lessons for Indian banking, this episode has once again brought to focus the old issue of the trade-off between price stability and financial stability, and how should central banks deal with this. The roots of the SVB collapse lie in the policy decisions taken during the pandemic, when the US Fed first injected abundant liquidity into the system, and then aggressively raised interest rates to fight inflation.

The crucial question therefore is: should a monetary authority (for example, the Fed or the RBI) take financial stability into account when setting its monetary policy or be guided by the mandated objectives of inflation control and economic growth? The SVB episode is likely to reignite the debate on this issue.

Four principles to be followed in RBI’s loan restructuring

MoneyControl, August 21, 2020 (with Harsh Vardhan)

In the aftermath of the 2008 Global Financial Crisis, large-scale debt restructuring had taken place in the Indian banking sector. Just about a decade later the Reserve Bank of India finds itself in a similar situation with demands from multiple stakeholders for a recast of the bad loans that would soon pile up on the balance sheets of banks. This time around the context is the ongoing Covid-19 pandemic, and the unprecedented challenges imposed by the resulting economic crisis on India’s businesses. The previous experience had given ‘restructuring’ a bad name. Can this time be made different?

In the post 2008 period, a series of restructuring schemes offered by the RBI to the banking sector had facilitated an ‘extend and pretend’ approach. The underlying asset kept deteriorating for years. When the RBI initiated an asset quality review in 2015, the non-performing assets skyrocketed. This episode triggered a prolonged phase of low growth-low investment in the economy.

As the RBI embarks upon a similar project, lessons from this experience should guide the current thinking. RBI has already issued first-order guidelines that set out key boundary conditions for the restructuring scheme. A next level of filters is now required to prevent a repeat of the past mistakes. To this end, we outline four principles that we think should be embodied in any restructuring scheme that the RBI offers.

Avoid Type 1 and Type 2 errors

The impact of the pandemic and the associated lock down is highly uneven. While some sectors (e.g. hospitality, aviation, automobiles) have been severely impacted, the shock to some other sectors (e.g. pharmaceuticals and fast moving consumer goods) has been modest. Some sectors (e.g. telecom, internet based services) have benefitted from this episode. Even within a sector, businesses have experienced varying degrees of stress depending on their size, financial constraints, geography of their operations, etc. Restructuring must be permitted only for those firms that have been badly hit by the pandemic and not to those who were financially stressed before the outbreak of Covid-19.

In deciding which borrowers get the restructuring, we must avoid what statisticians refer to as Type 1 and Type 2 errors. Type 1 error occurs if a deserving borrower is denied restructuring. Significantly more pernicious from the perspective of the banks and hence the economy, is a Type 2 error where non-deserving borrowers get restructured. Widespread Type 2 errors can ultimately impose a heavy cost on the rest of the economy especially when 70% of the banking system is owned by the Government.

The bankers themselves are best placed to judge if a borrower deserves to be restructured. Hence, one way to avoid these identification errors would be to let the bankers exercise their discretion and judgement as opposed to the banking regulator prescribing the rules.

Ensure accountability of bankers

Restructuring schemes offered by the regulator are by definition accompanied by forbearance and create a risk of moral hazard. In absence of the necessary checks and balances, bankers may get tempted to recast the debt of all their borrowers because they get to keep their books clean. This is especially relevant in cases where a bank’s CEO is about to retire soon. Hence it is important that bankers have a skin in the game and are held accountable for the decisions they take.

This can be achieved in two ways. First, the provisioning requirements on restructured loans must be higher than standard assets and lower than NPAs. There must be an incremental cost of restructuring. Second, adequate disclosures must allow a wide range of external stakeholders to assess the actions of bank management.

Minimise information asymmetry through enhanced disclosures

When a bank implements a restructuring scheme, the information asymmetry goes up. The regulator must take necessary steps to reduce the opacity of the deal struck between the bank and the borrower. This is important because banks deal with public money and with majority of the sector owned by the Government, any lapse on the part of these banks ends up imposing a cost on the tax payer.

The most important way to reduce information assymetry and enhance accountability of bankers is to demand disclosures. Previous restructuring schemes were characterised by scant disclosures and hence the various stakeholders in banks – stockholders, bond investors, other borrowers, depositors, employees, etc had little information.

Any scheme must be accompanied by extensive disclosures on various aspects of the restructuring such as amount of loans restructured, the sectoral break up of restructuring, the stage in the lifecycle of the loan when restructuring is done, assessment of the bank management on the recoverability of the loan, the timeline of recoverability, key conditions of restructuring, and so on. These disclosures should be mandated on a quarterly basis with regular updates on the performance of the restructured portfolio.

Impose conditionalities on borrowers

The borrower who qualifies for a loan recast must pay some price in lieu of the relief obtained, as otherwise there maybe little incentive to abide by the terms of the scheme. The underlying assumption of the relief is that the cash flows of the borrower are impacted by the pandemic and are inadequate to service debt. In that case, the borrower must not be permitted any other discretionary uses of cash flows. Specifically, borrowers must not be allowed to engage in acquisitions, share buybacks and delisting, dividend payment, and even variable compensation to senior management, as long as any of their loans is getting restructured. These restrictions should be the pre-conditions for restructuring.

As we enter into yet another phase of debt restructuring, it is important to note that restoring the health and stability of the banking sector is critical for the recovery of the economy from this crisis. While restructuring provides short-term relief, it does not solve the underlying problem. Most often the hope is that the system will grow out of the crisis and the problem will go away. In the last round of restructuring this hope had backfired. It is vital that we avoid a repeat of that episode this time around.

Modi government and RBI can learn from mistakes made during 2008 crisis, but time’s running out,

The Print, August 19, 2020

Five months into the lockdown, the Covid-19 pandemic is nowhere near its end, while the economy continues to steadily deteriorate. The pandemic is unprecedented in modern India, but its economic impact is familiar: a toxic mix of poor growth, high inflation, and numerous bad loans, similar to the period after the 2008 Global Financial Crisis. This means we can look to the 2008 crisis for lessons that can help us avoid policy mistakes, especially with respect to inflation and bad loans.

Inflation pressure

Let’s first consider inflation. In the aftermath of the Global Financial Crisis (GFC), the Reserve Bank of India (RBI) responded aggressively, lowering the policy rate by more than 4 percentage points in just four months, to 4.75 per cent in December 2009. At the time, the RBI felt it was safe to relax its monetary policy stance, since the wholesale price index (WPI) inflation had collapsed. But the respite in inflation proved temporary, and soon the WPI was rising at a double-digit pace, causing inflation expectations to soar. Bringing this situation under control proved to be difficult. It was not until 2013, when policy rates had been increased to painful levels, that inflation finally began to subside.

In retrospect, the RBI made two mistakes. First, it focused on the WPI, even as more comprehensive indices were signalling towards growing inflationary pressures. The erstwhile CPI (Consumer Price Index)-industrial workers series exceeded 12 per cent, as early as 2009-10. Second, and more critical, even after the WPI itself began to rise the RBI was slow to respond, since it always had reasons to hope that the increases would be temporary.

When the current Narendra Modi-led government came to power in 2014, it seemed determined to not let such a harrowing episode be repeated. Accordingly, it introduced into law a new monetary policy regime, committing the RBI to keeping inflation within a 4-6 percent range, as measured by the CPI — not the WPI. If inflation did exceed 6 per cent for three consecutive quarters, the RBI was required to explain in a report to the government, in a report, what it was doing to bring inflation back to target levels.

The RBI now finds itself in precisely the situation that the law meant to safeguard against? CPI inflation has exceeded 6 per cent for the past 10 months. But the reaction of the RBI has been the same as it was after the GFC. The central bank has been reluctant to increase interest rates, on the grounds that high inflation triggered by supply side constraints is temporary. Without doubt, prices have been pushed up by supply disruptions during the lockdown period, and these will eventually disappear. But the process of restoring supply chains might easily take a year, by which time high inflation expectations could become firmly entrenched. Hence, there is a risk that despite all the efforts to ensure post-GFC mistakes never happen again, they are about to be repeated.

Covid's bad loan crisis

So much for inflation. What about bad loans? After the GFC, slower growth and higher interest rates rendered unviable many of the investment projects initiated during the 2004-08 boom. , making This made it impossible for many firms to repay their bank loans. The RBI responded with a series of restructuring schemes, which failed to resolve the problem. Instead, the schemes facilitated an ‘extend and pretend’ policy which enabled the banking sector to hide the bad loans for years.

The delay in resolution of the stressed assets triggered a prolonged phase of low investment-low growth in the economy, and high risk aversion in the banking sector, from which the economy still hadn’t recovered when it was hit by the Covid-19 pandemic. As these consequences became apparent, the Modi government brought in the Insolvency and Bankruptcy Code (IBC), mandating that bankrupt firms be resolved expeditiously, and in a transparent manner, essentially by auctioning them off to new, financially stronger, owners.

For a time, the IBC was indeed able to whittle down the stock of bad loans. But the Covid-19 shock generated a new wave of stressed assets, which according to the RBI’s latest Financial Stability Reports is likely to propel nonperforming assets (NPAs) to a new peak of 12.5 per cent by March 2021, even under a favourable scenario.

Going forward

It is unclear how the authorities plan to deal with this problem. So far, the government has suspended the initiation of fresh insolvency proceedings for a year, while the RBI has appointed a committee to recommend new restructuring guidelines.

If the new restructuring guidelines follow the same ‘extend and pretend’ strategy chosen after the GFC, the outcome will be the same as before. Or possibly worse, given that in 2008 the corporate and banking sectors were comparatively stronger, whereas even before the virus hit in 2020, they both had been substantially weakened by years of balance-sheet stress. Hence, the effects of delaying resolution this time might be more serious. If the banking sector gets paralysed, unlike the post-2008 period, borrowers will no longer be able to turn to the non-banking finance companies (NBFCs), since the NBFCs are also in a weak condition now.

India, thus, stands at a crossroads now. Soon, the Modi government and the RBI will need to decide whether to deal quickly and decisively with the economic problems that Covid-19 has created, or wait and watch in the hope that they will disappear over time. The stakes in this decision are high, since it will determine the course of India’s economy for the next decade.

Looking back, the GFC episode makes it clear that the decisive strategy is superior. What is unclear is whether this lesson has truly been learned. And we all recall American philosopher George Santayana’s admonition: if we do not learn from history, we are doomed to repeat it.

RBI vs. Covid-19: Understanding the announcements of March 27

RBI vs. Covid-19: Understanding the announcements of March 27, Ideas for India, April 7, 2020.

Covid-19: Policy Challenges And Traps In Restarting The Economy

Bloomberg Quint, April 6, 2020 (with Harsh Vardhan)

It is now widely acknowledged that the scale of the economic damage caused by the Covid-19 pandemic will be far greater than that caused by the 2008 global financial crisis, globally as well as for India.

There exists considerable uncertainty about the duration and depth of the crisis but one thing is becoming increasingly clear: dealing with the after-effects of Covid-19 will be a major economic policy challenge over the next few years. While some policy actions have been announced by the government and the Reserve Bank of India, they are interim measures and are not going to be adequate to support the economy. Given the uncertainty, policy responses are likely to be reactive. Here, we discuss a few challenges in fiscal, monetary and financial policies and also lay out some policy traps that must be avoided in order to prevent a long-term economic disaster.

Fiscal Conundrum

Let’s start with fiscal policy. Even assuming a conservative scenario where the government does not incur any additional expenses due to Covid-19, the deficit will be greater than the projected value in the 2020-21 budget. During the ongoing three-week-long lockdown, almost all economic activities have been suspended and most of these are unlikely to resume in the near future given the nature of the health shock. As a result, government revenues will fall drastically. Given the depressed equity market condition and global economic uncertainty, the disinvestment targets are unlikely to be met. Over and above this, much of the policy actions required to minimise the economic fallout of the shock will involve government spending.

It is almost certain that the government will not be able to adhere to its fiscal target for 2020-21 and will most likely breach it by a big margin.

In India, the fiscal deficit is supported by financial repression wherein the government borrows from a captive market of banks and other institutional lenders. In the pre-Covid19 period, total central and state government borrowing had already exceeded total household savings. Further borrowing will sharpen the yields in the bond market and crowd out private capital at a time when a large number of firms and households will need to borrow to stay afloat. The large-scale income losses of many businesses and households that are inevitable during this crisis imply that the savings rate is likely to fall. These factors leave little room for the government to increase its domestic borrowing.

Recently, a scheme has been announced to encourage foreign investment in government securities. With the global spread of the pandemic, foreign portfolio investors have already been taking money out of the Indian capital markets. Given the widespread risk aversion, it is unlikely that this route will bring in a lot of financing for the government. If anything, the widening fiscal deficit may lead to a sovereign rating downgrade or a lowering of the macro outlook which in turn will increase the risk premium demanded by FIIs. Therefore, the biggest policy challenge now will be financing the rise in the government deficit. The only favourable factor in this regard is the sharp decline in global oil prices which are expected to remain subdued given the worldwide decline in demand for oil.

The Risks To Print-And-Spend

Next comes monetary policy. There are now calls from certain quarters for the RBI to print money to finance the rise in the fiscal deficit, a practice that was prevalent in India but discontinued since 1997. Monetisation of fiscal deficit will create inflationary pressures, lead to greater uncertainty about future inflation, increase long-term interest rates and adversely impact growth, thereby defeating the very objective of supporting the economy.

All efforts to flatten the Corona curve would steepen the yield curve.

This move will violate India's inflation-targeting framework and attenuate the effectiveness of future monetary policy actions. It will also hurt the credibility of the government.

Financial Freeze?

Finally, in the financial sector, banks and non-banking finance companies will witness a precipitous rise in non-performing assets, both from the private corporate and the retail sectors as firms and households struggle to deal with this unprecedented shock. A large number of firms especially the micro, small and medium businesses and also self-employed individuals are likely to default on their bank and NBFC loans.

Rising NPAs will erode the capital of lenders at a time when they are expected to lend aggressively to revive economic growth.

With the stock market touching new lows every day, it will be difficult for private banks to raise capital and the strained fiscal situation will make it difficult for the government to recapitalise the public sector banks. Capital deficiency in the face of rising NPAs will lead to demands for ‘forbearance’ from the RBI. There may also be further easing of capital requirements by tweaking the risk weights or outright reduction of capital adequacy requirements, on the basis that Indian requirement has been tighter than international standards. The net result of such regulatory concessions would be that the banking sector will remain undercapitalised for some time and will hide its losses.

Rules Matter

When the Covid-19 shock hit India, the economy was still recovering from the twin balance sheet crisis, the seeds of which were sown in the years of regulatory forbearance of the post-2008 period. Postponement of NPA recognition helps to 'extend and pretend'. Soon the problem becomes too big to tackle and the damage to the economy becomes long-lasting. If allowed now, this will lead to a system-wide crisis as it did in 2016-17 post the asset quality review by RBI.

Defaults by firms would trigger a wave of bankruptcies.

The Insolvency and Bankruptcy Code has introduced, for the first time, a rigorous and disciplined process for dealing with bankruptcies. There will be a demand now to dilute the provisions of IBC. This could undermine the most important reform of the last decade and render the code ineffective.

In such extraordinary times, the temptation to ignore rules and frameworks, and apply discretion runs high. This approach is neither effective nor sustainable. Over the last two decades several important policy frameworks have been put in place – FRBM, inflation-targeting, Basel norms, IBC, etc. These frameworks provide institutional support to policy decisions and must be adhered to in the interest of the long-term health of the economy. Policy responses to the ongoing crisis potentially risk undermining these frameworks and must be decided with utmost care and caution.

Banking crisis impedes India’s economy

Banking crisis impedes India’s economy (with Harsh Vardhan), East Asia Forum, October 3, 2019.

Firm survival in India: Status of firms formed over the last 30 years

Firm survival in India: Status of firms formed over the last 30 years (with Manish Singh), Ideas for India, June 12, 2019.

The Indian bankruptcy reform: old defaults vs. recent ones

The Indian bankruptcy reform: old defaults vs. recent ones, The Leap Blog, April 11, 2019.

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.

Commercial wisdom to judicial discretion: NCLT reorients IBC

Commercial wisdom to judicial discretion: NCLT reorients IBC The Leap Blog, December 13, 2017 (with Pratik Datta).

Understanding the recent IBC (Amendment) Ordinance, 2017

Understanding the recent IBC (Amendment) Ordinance, 2017 The Leap Blog, December 7, 2017 (with Anjali Sharma).

NPA Ordinance: The impact of secrecy in ordinance making

NPA Ordinance: The impact of secrecy in ordinance making The Leap Blog, June 30, 2017 (with Pratik Datta).

Bank financing of stressed firms

Bank financing of stressed firms Ideas for India, June 7, 2017 (with Anjali Sharma).

Banking ordinance opens up Pandora’s box

Mint, May 23, 2017 (with Anjali Sharma)

The recently promulgated Banking Regulation (Amendment) Ordinance is aimed at resolving the non-performing assets (NPA) crisis in the banking sector. It creates an illusion of state action, and does little by way of addressing the real concerns. We highlight some of the problems created by the ordinance.

Resolution of NPAs is a two-stage process. The first stage involves assessing the viability of the debtor’s business. The second stage involves deciding whether the debtor’s company should be restructured or liquidated. Any such resolution, be it restructuring or liquidation, imposes losses on the banks that had lent money to the corporate debtor. The larger the losses, the higher the amount of capital needed by the banks to meet the Reserve Bank of India’s (RBI) guidelines on provisioning requirements. While the government has promulgated the ordinance, it has not made any commitment of additional capital to support the resolution efforts. Capital allocated for the banking sector in the 2017-18 Union budget, or as part of the mid-term capital infusion plan, falls short of what the banks collectively need.

In absence of additional capital, the RBI’s directions to the banks under the ordinance may impede the resolution process. The RBI may have no option but to direct the banks to extend lifelines to unviable companies to defer the problem to a future date. This can happen as part of the new Insolvency and Bankruptcy Code (IBC) or otherwise. As pointed out in the Economic Survey 2016-17, over the last few years, cash flows of the large stressed companies have been declining. Restoring their viability necessitates loan write-offs. For the banks, resolving these cases requires the most capital. Given the lack of capital, banks could be given the regulatory cover under the ordinance to refinance these large corporate debtors. We have already seen this happen under the RBI’s corporate debt restructuring (CDR) mechanism. The ordinance does not change the status quo where good money is thrown after bad and no real resolution of NPAs takes place.

Second, resolving a bank’s NPAs requires resolving the entity to which money has been lent. The ordinance may instead create perverse outcomes. Under IBC, banks as members of the creditors’ committee are required to vote on a resolution plan. If the RBI directs a bank to initiate IBC action against a corporate debtor, it may also have to direct the bank on the decisions in the creditors’ committee. By empowering the RBI to act, the government has taken away any incentive of the banks to act on their own. In India today, different banks are at different levels of capital adequacy. An IBC resolution plan that works for one bank may be inimical to the interests of another. As the banking regulator, RBI is responsible for the health of all banks. So it is possible that the resolution plan that finally gets approved by the banks under RBI’s directions will focus more on the health of the banks as opposed to addressing the insolvency of the corporate debtor. This defeats the purpose of an IBC resolution.

Third, RBI giving directions on the resolution of banks’ NPAs may undermine the IBC process in other ways too. It may thwart the incentives of third parties which would have otherwise been willing to offer their bids or resolution plans in a market-driven process.

Fourth, with the ordinance in place, all eyes are now on the RBI to resolve the NPAs of the banking sector. This could be problematic because the range of actions that the banks can take to address the problem is limited by the shortage of capital. The tools available to RBI are limited. If the RBI intervenes on a case-by-case basis, questions about conflict of interest, regulatory capacity and capability will arise. If RBI intervenes through general rules and conditions, this will be no different from the corporate debt restructuring (CDR) mechanism, the strategic debt restructuring (SDR) scheme, and the scheme for sustainable structuring of stressed assets (S4A) that have failed in the past to resolve the problem. Either way, the ordinance puts RBI’s credibility and reputation as a micro-prudential regulator at stake.

Fifth, non-commercial factors may also be at play when it comes to resolving the large NPA cases. In the absence of clarity on the rationale behind the ordinance, we conjecture that one reason banks have not been initiating resolution proceedings against the large stressed companies is because of pressure from politically connected promoters. The ordinance gives banks the regulatory cover to take resolution-related decisions but it is not clear whether it also gives the required political cover. If the RBI is to now get directly involved in these loan restructuring decisions, or indirectly through committees reporting to it, this would put it in a difficult spot.

Finally, public and private sector banks have non-government shareholders, and non-bank creditors. So do companies that may get referred to the IBC following RBI’s directions to the banks. Any action under the ordinance that adversely affects the interests of these parties may be litigated in court. In a litigation if courts take cognizance of the rights of private shareholders and rule in their favour, this can further weaken the IBC process. Also private parties, domestic and foreign, may view this as state interference in market processes. This may affect their future investment decisions.

The ordinance was presumably brought about because banks on their own could not trigger IBC proceedings against the stressed companies for fear of investigation and prosecution, or due to lack of capital or because of challenges in negotiating with politically connected promoters. The ordinance gives banks the regulatory cover to take resolution decisions, but it is, by design, limited in its capacity to resolve the crisis. It opens up a pandora’s box of new problems. Most importantly it puts the RBI in a difficult spot and makes the IBC vulnerable to potential abuse. It also creates the problem of misaligning creditors’ and debtors’ incentives farther away from an effective resolution.

Understanding the recent Banking Regulation (Amendment) Ordinance, 2017

Understanding the recent Banking Regulation (Amendment) Ordinance, 2017 The Leap Blog, May 8, 2017 (with Pratik Datta).