The timing of the new ordinance empowering the Reserve Bank of India (RBI) to get more actively involved in the stalled resolution process can hardly be faulted. After all, recalcitrant bankers have allowed bad loans to fester on their balance sheets for far too long. These bad loans—an estimated Rs9.64 trillion—are now the biggest single threat to Indian economic stability. The potential costs of a clean-up have also mounted.
Over the past few years, the RBI had done well to force banks that were obstinately hiding their problems to come clean in their asset quality reviews. It then gave banks freedom to deal with distressed loans by allowing, for example, the lenders to convert debt into equity through strategic debt restructuring (SDR) or by helping companies rework repayment schedules through the scheme for sustainable structuring of stressed assets (S4A). The underlying idea was clear. Since India did not then have an effective bankruptcy law, the regulator sought to create a resolution system that resembles the out-of-court bankruptcy process.
This strategy did not work as expected. The Narendra Modi government has now decided to take matters into its own hands—or, rather, to push the Indian central bank deeper into the battle. It has got presidential assent for an ordinance that empowers the RBI to force banks to act. In effect, the previous decentralized system empowering bankers in bad loans resolution is being replaced with a more centralized one empowering their regulator.
The Indian central bank can now “issue directions to banking companies for resolution of stressed assets” and also “issue direction to any banking company to initiate insolvency resolution process in respect of a default, under the provisions of the Insolvency and Bankruptcy Code, 2016”. The first will hopefully force banks to write down debt to match its economic value while the second will ensure that banks do not throw good money after bad on projects that have no future. The new resolution strategy seems to depend heavily on not just the omnipotence of the RBI but also its omniscience. The former is more credible than the latter.
The RBI has the ability to force banks to act fast, or at least faster. It also provides credible cover to bankers who are afraid that taking haircuts on loans—or settling them at a discount to their book value—will later land them into the eager hands of overenthusiastic investigative agencies. The Modi government thus seems to be hoping that the central bank will solve what is essentially a collective action problem.
The choice of RBI as the agency to push for resolution is a strange one. The international experience shows that central banks mainly intervene in banking crises by providing emergency liquidity. It is the government that moves in to push for the resolution of distressed debt. There are many models here—including a bad bank. But it is hard to find any other recent example of a central bank being tasked with a banking sector clean-up. Chile is perhaps the only notable exception. In 1982, in the midst of an economic crisis, its central bank bought bad loans at face value, with a repurchase agreement to sell them back to banks when financial stability returned. It also swapped corporate dollar debt for local currency debt at below market exchange rates.
The switch to a more centralized mode of distressed debt resolution is understandable given the minimal success of previous schemes, and global experience shows that government action is needed when the bad loan problem crosses a certain threshold, but is the RBI the best agency to do this? There were two alternatives.
First, the dormant Bank Boards Bureau (BBB) could have been used to provide cover to bankers scared of selling loans at discounts. Second, the Financial Sector Legislative Reforms Commission had recommended the setting up of a resolution corporation to deal with distress in financial firms. It is not clear why the Modi government chose the RBI instead. The Reserve Bank of India Act does give it considerable operational control over banks, and the new ordinance adds to that firepower, but getting the central bank involved in the micromanagement of the bad loans problem is a worry.
What now? The new ordinance may accelerate the resolution process, especially since the new bankruptcy law is now in place. But be warned: This does not mean the underlying challenges have gone away. Three challenges are worth mentioning. The first challenge is to find buyers for the distressed debt that banks may want to sell or for assets if enterprises are wound down under the bankruptcy law. The second challenge is that capital needs to be raised after banks take a knock with the inevitable loan write-downs; the combined bill for cleaning-up banks as well as meeting Basel III norms is around $100 billion. The third big question, and a politically sensitive one, is to what extent corporate borrowers rather than taxpayers will bear the costs of bad loan resolution.
In other words, there is still a tough journey ahead for Indian banks.
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