Supreme Court’s Bhushan Steel Ruling: A Test for India’s Insolvency Regime

Business Standard May 20, 2025

The Supreme Court’s recent decision to liquidate Bhushan Power and Steel Limited (BPSL), five years after its resolution plan was approved and implemented, has sent shockwaves through India’s corporate and financial sectors. By overturning JSW Steel’s takeover of BPSL, the ruling has raised fresh questions about the Insolvency and Bankruptcy Code (IBC) and the institutions responsible for enforcing it.

A Landmark Reversal

In a major reversal, the Supreme Court ruled that the resolution plan for BPSL—approved by the Committee of Creditors and cleared by both the insolvency and the appellate tribunals (National Company Law Tribunal or NCLT and National Company Law Appellate Tribunal or NCLAT)—suffered from procedural lapses and non-compliance with the IBC. The Court found the process fundamentally flawed, ordered the return of payments made by JSW Steel to creditors, and directed BPSL’s liquidation. This decision, coming after years of revival of BPSL, could lead to major losses for creditors, who now risk recovering less through liquidation than under the earlier resolution.

Implications for the IBC

Introduced in 2016, the IBC was hailed as a major financial reform in India. It aimed to unlock capital from failed businesses, improve credit discipline, and enhance resource allocation efficiency. Its success in resolving major bad loans strengthened the financial sector and boosted investor confidence.

However, the Supreme Court’s recent ruling has cast a shadow over its future. By overturning a resolution plan years after completion, the decision has created uncertainty for creditors and investors, raising concerns about the IBC’s effectiveness.

Institutional Failures Exposed

The judgment strongly criticises the institutions involved in the BPSL case. The NCLT and NCLAT, institutions central to the IBC framework, were faulted for approving a flawed resolution plan, while the Committee of Creditors (CoC) was reprimanded for poor judgment and supporting a plan that breached legal timelines and rules. The Resolution Professional (RP) was blamed for delays and legal lapses exposing weak oversight by the Insolvency and Bankruptcy Board of India (IBBI), the regulatory body for IBC.

The Case for Reform

Much of the commentary following the judgment has called for changes to the IBC, but the real problem lies with the institutions enforcing it, not the law itself. The success of the IBC hinges as much on a sound legal framework as on the capability and integrity of its implementing bodies.

Strengthening the NCLT and NCLAT is essential, as they face persistent understaffing, shortage of benches, and limited use of technology. Many judges come from civil courts and may lack expertise in complex commercial cases. Regular training in insolvency law and allowing the use of amicus briefs in complex matters could help improve the quality of their decisions.

The oversight of the RPs by the IBBI also needs urgent reform. Though the board certifies the professionals, its ability to monitor their actions and hold them accountable remains uncertain. Stronger enforcement powers and clearer guidelines are needed to ensure RPs meet their legal and fiduciary responsibilities.

The CoC plays a central role in the resolution process under the IBC. However, the Supreme Court’s criticism highlights a key issue: to what extent should courts review the CoC’s decisions? Since creditors are expected to act in their own commercial interests, their decisions should generally be insulated from judicial scrutiny. While judicial review of procedural lapses is justified, questioning the CoC’s commercial judgment is more problematic, also because there are no clear benchmarks for such assessment. Excessive judicial intervention risks undermining the very foundation of IBC.

Economic Consequences

The economic impact of this judgment is far-reaching. Banks must now return funds received from JSW Steel, leading to higher provisioning and potential losses for them, while JSW Steel itself may struggle to recover its investments in BPSL. The uncertainty triggered by this ruling could make future bidders demand higher risk premiums or avoid distressed assets entirely, further complicating the resolution of bad loans.

This decision could freeze capital, erode investor confidence, and slow private investment—all key factors crucial for India’s goal of becoming a developed economy by 2047.

Legal issues

The SC’s decision to retrospectively undo an acquisition approved years ago and order liquidation of a now-profitable company is also troubling. While procedural lapses may have occurred, the proportionality of the punishment is debatable. A statute of limitations on judicial intervention in IBC cases could help prevent such reversals. Without it, the risk of the court overturning settled decisions may deter potential bidders from participating in the resolution process.

A Cautionary Tale

In summary, the Supreme Court’s ruling in the BPSL case exposes deep flaws in the IBC’s institutional framework and raises concerns about judicial overreach. To sustain financial sector reforms and attract long-term investment, policymakers must urgently address these issues. Restoring confidence in the IBC requires institutional as well as judicial reforms. Only by building competent, accountable institutions can the IBC’s full potential be realised and the interests of creditors, investors, and the broader economy protected.

The post-pandemic credit landscape in India

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

Covid-19 crisis: Response should not undermine institutions

Covid-19 crisis: Response should not undermine institutions, Ideas for India, December 15, 2020.

India's banking sector: a liability for monetary policy effectiveness?

India’s banking sector: a liability for monetary policy effectiveness?, East Asia Forum, October 16, 2020.

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.

Policymaking at a time of high risk-aversion

Policymaking at a time of high risk-aversion, Ideas for India, April 6, 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.

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.

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.

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).