Insolvency and Bankruptcy Code Takes a Hit: Boon or Bane? - Views on News from Equitymaster

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  • Apr 11, 2019 - Insolvency and Bankruptcy Code Takes a Hit: Boon or Bane?

Insolvency and Bankruptcy Code Takes a Hit: Boon or Bane?

Apr 11, 2019

Non-performing Assets (NPAs) is the smoking gun of the threat to the very stability of India's banks.

India badly needed a magic pill that would revitalise the system, curing the bad loan problem.

The Reserve Bank of India (RBI) had pointed out the lack of modern bankruptcy legislation in India which was affecting the recovery of loans since quite a long time.

When it comes to resolving insolvency, India's rank is low at 103. This is much below our neighbouring countries.

On both factors - the recovery rate and the time to resolve a bankruptcy - India is slower than its poorer neighbors.

India Slowest in Resolving Bankruptcy

There was a need to revamp bankruptcy laws. Which brings me too...

Revealing Tomorrow: The Great Indian Wealth Project

12 February 2018 RBI Circular

In a bid to stem the lurking rot, the Supreme Court quashed the 12 February 2018 RBI circular on non-performing assets.

Now what was this buzz all about and what does it mean?

In a circular on 12 February 2018, the RBI mandated banks to classify loans of Rs 20 billion and above as 'stressed' if their repayment remained overdue even for a single day.

Thereafter, a window of 180 days would open during which the lenders and the borrower had to agree upon a plan to resolve the default.

If the non-payment problem persisted beyond 180 days, the lenders would get a free hand to take over the firm, sell it or liquidate it under the IBC. Read more about the Insolvency and Bankruptcy Code.

The Timeline of the Issue

  • 4 May 2017 - The government of India issued an order to amend the Banking Regulation Act that conferred powers on RBI to issue directions to banks. It included directing banks to refer NPAs to the insolvency and bankruptcy courts.
  • June 2017 - The RBI issued a list of the 12 largest loan accounts in default. The banks were required to start proceedings under the IBC.
  • 12 February 2018 - The RBI came out with a new resolution framework, to be used by banks before triggering the IBC.

Banks had no choice but to trigger IBC if the loans were not restructured within a deadline.

Finally, the previous mechanisms the RBI had created pre-IBC were all withdrawn.

These mechanisms - Joint Lender's Forum (JLF), Corporate Debt Restructuring (CDR), Scheme for Sustainable Structuring of Stressed Asset (S4A), and Strategic Debt Restructuring (SDR) had all been criticised for being too easy on borrowers.

The schemes allowed for ever-greening of loans, where the banks would pour more money in a company which had already defaulted and were generally considered to be poorly designed.

Now, as per the 12 February circular, the RBI disclosed the top 12 loan defaulters accounting for around 25% of the total bad loans.

As the chart shows, the biggest defaulter was Bhushan Steel with bad loans of Rs 559 billion.

Top 5 Defaulters

The Insolvency and Banking Code was expected to tackle the growing bad loans problem.

Now here's a thing to note...

In case of Tata Steel buying out Bhushan Steel, banks recovered 63% of their outstanding loans, which was very good.

But in case of Alok Industries, the banks could recover only around 16% of the outstanding loans .

Typically, banks managed to recover around 10% of the bad loans in the past. Of course, the Insolvency and Bankruptcy Code led to a recovery rate better than 10%, but it didn't change the state of public sector banks much.

Then on 2 April 2019 the Supreme Court set aside the RBI's 12 February 2018 circular. This restored previous all the previous debt recast options for the defaulting companies. It gave a free hand to banks to explore steps to rescue such companies outside the court.

This came on the back of power, shipping and sugar companies challenging the RBI's February 12 circular which had identified about 30 companies which were stressed. Many of them were power companies.

The effect of the RBI circular fell disproportionately on the power sector. The power sector has some genuine reasons for the high levels of defaulted loans.

Some of the blame for the failure to repay loans was due to government inactions, like the electricity regulatory commissions not updating the price of electricity, change in government policy on coal supply, failure to execute power purchase agreements, and the non-payment of dues by state electricity distribution companies.

Owing to the supreme court's verdict, shares of power companies hogged limelight throughout the day.

The Impact

1. IBC Versus Other Mechanisms:

A recent report by the Reserve Bank of India on the trends and progress of banking in India FY18, showed an interesting comparison on the efficacy of the IBC in improving the recovery rate and in providing the lenders with a better realisation in comparison to the erstwhile regime of recovery.

Recovery by Banks as % of Amount Filed

Also, reasearch analyst, Sarvajeet Bodas had pointed back then, things were about to change for the better. Here's what he wrote:

  • "This is a game changer for India's banking sector. The IBC gave banks the power they needed.

    Earlier, banks had to run after promoters to recover their money. Now promoters are running after banks and looking for solutions.

    As per the RBI's financial stability report, more than 4,300 applications were filed in the National Company Law Tribunal (NCLT).

    With this, banks have sent out a clear message - pay up...or be ready for bankruptcy proceedings."

But now after supreme court's order, banks plan for higher recovery through NCLT cases initiated becomes null and void.

2. Will the Provisioning Remain High or Will It Fall?

Now look at the chart below.

It shows gross NPAs to gross advances of the leading banks in India over the years. There has been a clear rise in NPAs and provisions in all the banks.

With the introduction of IBC, a loan worth over Rs 2.8 trillion, with payments outstanding for 60-90 days, carried the risk of slipping into the category of NPA. This resulted in a surge in NPAs and put additional pressure on the banks to make provisions.

The new framework specifies banks report defaults on a weekly basis in the case of borrowers with more than Rs 50 million in bank debt.

The strict timelines meant that a larger number of accounts would go into insolvency.

Provisions Increased Post IBC Code

The question now is will these banks maintain such high provisions for debt after the Supreme Court ruling?

If not, how will it impact NPAs again?

3. Signs of Credit Growth

The previous attempts to address the issue of bad loans had all failed.

As per an article in The Economic Times, after the code became operational, about 3,300 cases were disposed of by the adjudicating authority based on out-of-court settlements between debtors and creditors involving claims amounting to over Rs 1.2 trillion.

As a result, the credit growth that banks in India posted in December quarter of 2018, at 15.1% YoY, was not just very healthy. It was nearly 2 times GDP growth. But it was also back to the five-year high.

Will Credit Growth Remain High Going Forward?

Ultimately, the total flow of resources to the commercial sector in India, both bank and non-bank, and domestic and foreign (relatable to the non-food sector), have gone up.

These figures tell us the IBC was successful.

As per the reports, total debt estimated to have been impacted due to the RBI circular was Rs 3.8 trillion across 70 large borrowers. These companies will now get the earlier options for restructuring.

What Happens Now?

The IBC code had its own pros and cons. The economy, especially a few sectors, benefited up to a certain extent.

But this came at the cost of power, sugar and other sectors which suffered the most due this circular.

Now you can't deny the fact that, for the IBC to truly succeed, it was important the government let the central bank do its job independently and thwart systemic risks due to the bad loans.

What we truly need is a fair set of rules to set the banking house in order. Now, what the government and RBI does further to correct this remains to be seen.

Warm Regards,

Rini Mehta

Rini Mehta

Rini Mehta is a keen follower of the stock markets and economy. At Equitymaster, she covers daily stock market moves and broader market trends across Indian and global markets.

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1 Responses to "Insolvency and Bankruptcy Code Takes a Hit: Boon or Bane?"

Sanjeev Kumar Singh

Apr 12, 2019

I think through this article it is being tried to project that due to SC declaring 12th February circular invalid as it was not issued within RBI power to issue , the whole IBC process has been jeopardised. This is a very misleading approach to whole issue. Nobody suggested that IBC is not beneficial. In fact all the initial reference to NCLT was with approval of the Government and it is working. Problem with the RBI circular was that it was issued without requisite powers and it has formulae which is one fit solution for all problem. It had norms which were non implementable and the banks being afraid of CVC/ Vigilance were throwing all cases to NCLT to avoid responsibility for settlement. This would have eventually clogged the legal proceedings. Normally a circular which has a far reaching consequences on the economy cannot be left to wisdom of one or two directors of RBI. RBI, being a regulator should have issued draft circular much in advance for suggestions and then issued final circular after consultation. How can an institution claim to be a paragon of virtue. It has to also solicit opinions from all the concerned stakeholders including government. As far as all of us know RBI never consulted anybody before issuing the circular and has acted on its own and was not amenable to any changes despite the fact that the straight jacket formulae cannot be applied o all the situations.

Hence while agree with the fact that the IBC has brought some fear amongst the borrower and discipline within lenders,12th February circular cannot be justified as no institution is above law and circular such a far reaching consequences cannot be left to wisdom of a few people only.

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