## Monday, May 08, 2017

### Understanding the recent Banking Regulation (Amendment) Ordinance, 2017

On 4 May, the President promulgated the Banking Regulation (Amendment) Ordinance, 2017. This adds sections 35AA and 35AB to the Banking Regulation Act, 1949 ("BRA").

The first applications of this modified law are visible. Under these new provisions, the Government has issued an order authorising RBI to give directions to the banks. RBI in turn has issued a notification imposing additional conditions on banks with regard to the JLF and corrective action plan processes.

It may be worthwhile to note at the start that the BRA already gives RBI expansive powers to issue directions to banks (see here). This begs the question as to why was it necessary to amend the BRA to give powers to the RBI that it already has.

Many commentators think that this specific amendment will help resolve the banking crisis. As examples, see here and here. In this article, we ask three questions:

1. Will the Ordinance help solve the decision paralysis in banks?
2. Will it help solve the ongoing NPA crisis?
3. Will it help prevent a future NPA crisis?

### The Ordinance

The Ordinance adds two new sections to BRA:

Section 35AA: The Central Government may by order authorise the Reserve Bank to issue directions to any banking company or banking companies to initiate insolvency resolution process in respect of a default, under the provisions of the Insolvency and Bankruptcy Code, 2016.
Explanation - For the purposes of this section, "default" has the same meaning assigned to it in clause (12) of section 3 of the Insolvency and Bankruptcy Code, 2016.

Section 35AB: (1) Without prejudice to the provisions of section 35A, the Reserve Bank may, from time to time, issue directions to the banking companies for resolution of stressed assets.
(2) The Reserve Bank may specify one or more authorities or committees with such members as the Reserve Bank may appoint or approve for appointment to advise banking companies on resolution of stressed assets.

Ideally a new law should be released along with its rationale and background so that there is no ambiguity about its objective. This Ordinance does not have a clear rationale. It starts with a short preamble which is vague, and does not clarify the purpose of the amendment. Ideally, the full strategy for resolving the banking crisis should be visible as a single document. At present, no such document exists, and it is possible that the full picture can change in coming months. Lacking these critical documents, we are hampered in our analysis.

We conjecture that the Ordinance is aimed at solving two problems:

1. The Insolvency and Bankruptcy Code, 2016 (IBC) has already been implemented as a law and any banker is free to trigger it if there has been a corporate default. We speculate that bankers on their own may come under pressure if they try to initiate an insolvency resolution process under the IBC against politically connected corporate defaulters. Perhaps the amendment aims to address this problem.
2. Even as part of the resolution process, bankers may not want to take decisions for fear of investigation by investigating agencies such as as the CVC, CBI, CAG, or CIC and subsequent prosecution by the Courts. While there is anecdotal evidence of such fear of investigation and prosecution in individual restructuring deals, this could be applicable to resolution plans under the IBC also.

### In the early years, recovery rates under IBC will be rather low

Before we get to the analysis of the amendment, we need to envision what is coming in the evolution of the bankruptcy process in India. We conjecture that in the early years, recovery rates will be poor, for four reasons:

1. We must remember that the IBC is itself new. The institutional infrastructure for the IBC works poorly, as of yet. It will take time for IBC to work well (see Datta and Regy, 2017; Shah and Thomas, 2016).
2. India is short of professional participants in the Insolvency Resolution Process of the IBC. E.g. as yet foreign capital has been largely blocked. There will be fewer participants and the highest bid will be a bargain.
3. The IBC is best applied at an early stage in the difficulties of a company, but most existing NPAs have been ripening for many years. For those cases, there is really nothing to be done but to pick at the bones of the corpse.
4. Inexperienced creditors' committees are likely to turn down offers that look bad, and later discover that the recoveries in liquidation are worse. It takes capability in a creditors' committee to vote correctly. Even when human skills are present, decisions may often be adversely affected by policy and regulatory constraints. It will take time for those policy and regulatory constraints to be addressed.

For these reasons, we believe that in the early years, the recovery rates will be poor. This is an important building block of the analysis ahead.

### Question 1: Will this Ordinance help solve the problem of decision paralysis in banks?

When the banker has to trigger the IBC resolution process against a politically connected corporate defaulter, he is likely to face political pressure to not trigger the IBC. Even in the resolution process, the banker has to take decisions related to the restructuring of the company. The banker will sit in the creditors' committee and vote on critical issues such as how much haircut to accept and which proposed resolution plan to vote for. There could be allegations that the banker colluded with the promoter of the defaulting company for mala fide purposes such as helping the promoter buy off the company's assets at a cheaper price or approving large loan write-offs etc. More generally, there could be allegations of a corrupt nexus between banks, insolvency professionals, and bidders. Investigating agencies could get into the problem. The recent arrest of the ex-IDBI Bank CMD in connection with loans to Kingfisher Airlines has heightened the fear among bankers. Bankers have allegedly responded by refusing to take any decision on triggering the IBC or resolving the stressed assets problem.

Section 35AA of the amended BRA aspires to address the first problem. If an honest banker wants to initiate a resolution process against a corporate defaulter under IBC, but is under political pressure not to, he can turn to RBI. RBI can issue a direction to the relevant bank to trigger IBC. If RBI comes under political pressure, it can turn to the government which will authorise RBI to issue such directions. Will this work? It depends on the extent to which politically connected borrowers are able to influence RBI and the government.

Section 35AB of the amended BRA aspires to address the second element of the problem. If a banker wants to take tough decisions during the resolution process or choose a specific restructuring plan, but is afraid of the investigative agencies, then RBI can give regulatory cover to the banker by issuing specific directions under this section, requiring the banker to take the restructuring decision. The government does not have any role here. RBI on its own can issue directions to banks for resolution of stressed assets. Effectively, RBI's direction will give plausible deniability to the banker, using which he can subsequently justify his conduct and be free of the fear of investigation and prosecution.

Section 35AB is like a guarantee by one arm of the State to a firm that its commercial decisions will be protected from being questioned by another investigative arm of the State. Given the shortcomings on the rule of law in the working of the investigative agencies, it maybe relatively easier for them to go after the bankers but arguably much harder to do the same when RBI, a quasi-government body, is involved and hardest when it comes to government employees.

The protective guarantees by the State implicit in sections 35AA and 35AB should certainly provide some comfort to the bankers and help resolve the decision paralysis. However, this does not solve the underlying problems and raises some new questions: Should investigative agencies of the State be questioning the commercial decisions of banks? If investigative agencies can question commercial decisions of banks, why should they not be able to question the banking regulator if it is taking commercial decisions on behalf of the banks?

For good policy analysis, we should not just think through the optimisation of an honest banker. We should also think about what a corrupt banker will do. What will RBI do when confronted with a request from a banker? How will RBI staff determine that a request should be accepted or denied? What are the accountability mechanisms, and checks and balances, within RBI?

As argued above, in the early years of IBC, recovery rates are likely to be low. Newspaper stories will come out about sensational events where a Rs.1000 crore loan led to a recovery of Rs.100 crore. At that point, investigating agencies could come in, and the finger pointing could start.

We are reminded of the Lok Pal proposal. Advocates of the Lok Pal believe that all Indian government officials are to be mistrusted, but the Lok Pal is to be trusted. That is faith-based policy analysis. Successful policy reforms involve checks and balances, and not faith.

In short, we think more decisions about bad assets will be taken owing to the amendment, but there will be a new array of troublesome questions which will rapidly limit the extent to which it is effective.

### Question 2: Will this Ordinance help solve the current NPA crisis?

Let us consider two possibilities:

1. What happens if RBI directs banks under section 35AA to trigger IBC against the corporate defaulter?
2. What happens if RBI not only directs the banks to trigger IBC but also passes directions under section 35AB to the banks on what specific resolution plan to approve as part of IBC or directs the banks to initiate any non-IBC restructuring mechanism?

In the first case, while triggering IBC may provide a resolution outcome faster than other restructuring mechanisms, the recoveries from such resolution are likely to result in large losses, particuliarly in the early years. Banks will then have to recognise large losses on their balance sheets, losses that have been hidden until then (see Sharma and Sengupta, 2016). The implicit equity capital crisis will morph into an explicit capital crisis. As yet, there is no sign of additional equity capital even if banks were to trigger IBC under directions from RBI.

In the second case, this Ordinance gives powers to RBI to issue directions, and even to overrule the commercial judgement of the bankers during any resolution process. Will this help? This seems unlikely. Maximising the recoveries from an NPA requires commercial decision making. Bureaucracies in banks have done this badly; it is unlikely that the bureaucracy in RBI will do better. Commercial decision making is best done in for-profit private sector environments.

What about non-IBC resolution mechanisms: Could RBI direct their use to do better than the IBC-based processes? An entire alphabet-soup of restructuring mechanisms initiated by the RBI over the last few years (CDR, 5/25, SDR, S4A) have failed (see here, here, and here). Why would we believe that RBI's directions to banks under the new section 35AB will now succeed? Over the last few years banks were able to hide the actual extent of the bad news using the cover of these mechanisms. Further use of these restructuring packages may prolong the crisis instead of solving it.

### Question 3: Will this Ordinance help prevent NPAs in future?

Banking is a business and giving a loan to a borrower is a commercial decision. The corporate borrower maybe unable to repay the loan for any number of reasons. Lending decisions taken by an honest banker can also give rise to NPAs. The problem turns into a crisis when the NPAs are allowed to linger on for years and their volume become so large that banks' balance sheets become severely impaired. This eventually leads to a credit crunch in the economy and starts to affect investment and growth, as has been the case over the last few years in the Indian economy.

The job of a sound banking regulator is to prevent such possibilities through prevention (micro-prudential regulation) backed by cure (resolution). For years, RBI adopted a lax approach which helped banks hide bad news. Had RBI been more vigilant and taken appropriate actions early on, the ongoing NPA crisis could have been prevented from metastasizing. The amendment to BRA through this Ordinance further increases RBI's involvement in the commercial decisions taken by banks. However, the roots of the banking crisis lay in RBI's own internal functioning. This calls for improving the regulatory architecture, accountability mechanisms, and processes for executive/legislative/judicial functions. These are not seen in the Ordinance.

### Conclusion

A financial regulator should be like a referee in a football match.

In a football match, typically a higher organisation (for example, IFAB) writes the rules of the game and the referee enforces the rules on the players while supervising their actions. The players are free to play the game on their own within the framework of the rules.

In the case of banking, Parliament writes the Banking Regulation Act, and RBI writes the subordinate legislation under this. After this, banks should be commercially motivated, and RBI should blow the whistle when the rules are being violated. In reality, however, the way RBI does banking regulation is akin to the referee telling the players how to give passes and when to strike the ball. This is an extraordinary power given to a banking regulator which is unique to India. Resolution of stressed assets is fundamentally a commercial decision, not a regulatory one. Is it really the RBI's job to direct the banks on how to restructure stressed assets? RBI's job is to insist that bad assets are recognised, provided for, and that banks have adequate equity capital.

Given that RBI is already empowered by the BRA to direct the banks, the Ordinance seems much ado about nothing. As we have argued, it gives rise to new troublesome questions and will do little to solve the crisis at hand.

The Indian banking crisis is a major challenge to our economic policy establishment. A full strategy for addressing the banking crisis is required. As yet, this is not visible.

### References

Datta, Pratik and Regy, Prasanth, "Judicial Procedures will make or break the Insolvency and Bankruptcy Code", Ajay Shah's Blog, January 24, 2017.

Shah, Ajay and Thomas, Susan, "Indian bankruptcy reforms: Where we are and where we go next", Ajay Shah's Blog, May 18, 2016.

Sharma, Anjali and Sengupta, Rajeswari, "How will IBC 2016 deal with existing bank NPAs?" Ajay Shah's Blog, December 5, 2016.

Rajeswari Sengupta is a researcher at the Indira Gandhi Institute of Development Research and Pratik Datta is a researcher at the National Institute of Public Finance and Policy, New Delhi. The authors would like to thank Harsh Vardhan, Nelson Chaudhuri, Sumant Prashant and Shubho Roy for useful discussions

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