It is said that when you borrow a thousand rupees, you have to worry about repayment. But if you borrow a thousand crores, the bank has to worry. This is the bane of banking. Of course this does not mean that banks should stop lending for large projects.
The very business of banks is to lend money for investments, which in turn creates a new productive capacity, new jobs and economic growth. In doing so they assess the risk of such lending, and even after the loan is disbursed, they monitor the project and the loan until it is fully repaid. Most of such lending is against collateral that is pledged to the lender.
The notional or market value of the collateral is typically much higher than the value of the loan. This offers extra security in case of a loan default. But the fact is that in times of distress it is difficult to liquidate the collateral and recover any dues. The collateral may be in control or custody of the borrower. Or its value may sharply deteriorate with falling business conditions. Additionally there is legal protection available to the borrower that can thwart the recovery process. Such legal protection is a legacy from the past when loan sharks or usurious lenders exploited borrowers.
In India, the rights of borrowers became so strong that lenders were often helpless. Even to possess and liquidate the collateral the lender has to overcome legal hurdles like court orders or other delays. The latest example is of how one of India’s leading banks had to wait two years simply to gain access and auction the villa of an industrialist who is a declared willful defaulter. Banks’ rights got strengthened somewhat with mechanisms like Debt Recovery Tribunals for fast tracking, and the SARFAESI Act of 2003.
The bank recovery of bad loans is part of a bigger challenge of how to resolve bankruptcies in general. If a firm has become insolvent, how long does it take creditors to resolve the bankruptcy and salvage some value? This is an important metric that determines overall ease of doing business in global ranking done by the World Bank. On an average it takes up to four years to resolve an insolvent business in India, and recovery is about 20 percent of what is due.
That’s why India’s rank is 136 out of 169 countries. This is about to change with a landmark reform in the bankruptcy law. In May this year the Parliament passed the new Insolvency and Bankruptcy Code (IBC), which creates a new institutional structure for insolvency resolution. It consists of a new regulator called the Insolvency and Bankruptcy Board of India (IBBI) that will regulate new entities called Information Utilities (IU) and a new class of Insolvency Professionals (IP). The draft procedural rules that will apply to IU and IP’s are already out and will be finalised in the coming month. The regulations will cover areas like registration of the professionals and their agencies, and the process of resolution.
The new code envisages a tighter timetable for insolvency resolution, and will depend critically on the coexistence and smooth functioning of three entities: the regulator, the IU’s and the IP’s. The information utilities will be a central repository of data, and prevent misuse of bankruptcy process delays by serial defaulters. The IP’s is a new class, much like chartered accountants and lawyers, and will be regulated by a self-regulatory organisation, much like CA’s. The new code is expected to be functional in two months, and will change the landscape of bankruptcy resolution. It is not as if the rights of borrowers have suddenly been diluted.
Nor is it that lenders have been given greater teeth. But by introducing the objectivity of third party professionals, and a tight limit on timelines, the process will be more efficient and predictable. For instance, despite the SAFRAESI Act of 2003, and emergence of asset reconstruction companies (ARC), the recovery rate and the time taken for recovery has not improved much. The Debt Recovery Tribunals, specially set up to speed up recoveries, so that they wouldn’t get delayed in the conventional courts, are now themselves clogged.
The last two years have seen mounting non-performing loans in Indian banks. These are simply manifestation of older problems, not tackled at the right time, or postponed with wishful thinking. The older NPA resolution remains a stubborn challenge, which of course will not be solved by the new bankruptcy code. The Reserve Bank of India has suggested various measures, including restructuring, haircuts, debt for equity swap and lengthening of loan tenure (the 5/25 scheme). The government is also toying with the idea of a “bad bank” to store and dispose toxic assets. But beyond the inherited problems of NPA’s of the past, the new bankruptcy code and the insolvency resolution ecosystem, will impact new risk taking in a very positive way. It allows entrepreneurs and investors to take risks, and speedy resolution if those ventures fail.
This can drive the entire ecosystem to truly unleash entrepreneurship and to do so at scale and at the same time separate out egregious abuse of the banking system that has given business a bad name. The former is to be nurtured and encouraged and celebrated; the latter is to be put down with a heavy hand. Competitiveness and ease of doing business needs ease of setting up businesses (i.e. free entry) and also ease of winding them down (free exit). The latter is what will be enabled by the new Insolvency and Bankruptcy Code in a manner that is fair, objective and most importantly time bound.