Changing the culture of corporate credit
Despite the criticism, RBI’s decision requiring banks to report defaults of even a single day is a good one
Reserve Bank of India (RBI) deputy governor N.S. Vishwanathan gave a strongly worded speech on the resolution of stressed assets in late April. The timing should not come as a surprise. RBI’s announcement in February brought in a series of measures to strengthen the process through which stressed assets are identified and resolved. The measure that has attracted the most criticism is the regulator’s decision requiring banks to report defaults of even a single day. This move has been questioned by bankers, borrowers, those in government as well as those in opposition.
The commonly understood meaning of “default” is failure to meet an obligation. Labelling someone who is late on their payment by even a day as a defaulter is simply calling a spade a spade. Still, many believe that this is too bureaucratic and out of touch with reality. The reality of doing business today is that firms routinely ignore or miss repayment deadlines. This should not be the case. RBI’s move in February is a good one. To see this, it is worth considering each argument against the one-day move.
First, it is argued that being late by just a day is no sign at all of distress. In reality, repayment schedules are predetermined. Therefore, even a day of default is a lagging indicator of the stress in the borrower. Borrowers have sufficient time to organize funds. Failing to make payment due to a cash-flow problem is an indicator for a bank to take immediate action.
Second, it is argued that even if firms default due to distress, these are genuine borrowers who are put in a difficult position because payments due to them are delayed. Here again, it stands to reason that it cannot be a sign of financial health for borrowers to operate on razor-thin margins. All well-run firms learn to maintain buffers to tide over blips in their cash flow. Their inability to do so is evidence that the borrower may be too highly leveraged to deal with even temporary emergencies.
This rosy picture of efficiency may not hold for small firms where the market is inefficient. The fact is that the one-day rule does not apply to micro, small and medium enterprises (MSMEs) with borrowings of less than Rs25 crore. It is also a reality that borrowers work with public sector buyers where delayed payments are part and parcel of doing business. For such firms, there is no reason why the common knowledge of the cash-flow patterns in their industry cannot be taken into account in their repayment schedules when the loan is sanctioned.
Third, it is broadly asserted that the one-day rule will wreak havoc on the real economy. This is claimed to happen through several channels. In some cases, opponents of the rule are misinformed. Assets will still be classified as non-performing only after 90 days of default. The rule simply requires banks to disclose the event of a default immediately. There is little economic theory or evidence that doing so will cause harm.
In contrast, significant damage to the economy is caused by the large number of zombie firms that have been kept propped up by credit that they should not have received. This has impaired the ability of healthy firms to compete and make profits. Stressed firms, kept in business by the lack of an effective insolvency regime and underreporting by lenders, have hurt India’s economy. In this context, there is good reason to think that the RBI’s rules are good for the economy. First, the rule kills the information asymmetry that is created when a firm’s default goes unreported. Second, it promotes faster resolution of stress. Third, it improves the poor credit culture in corporate India.
Many of today’s zombie firms were the beneficiaries of the credit boom between 2003 and 2008. As early signs of stress manifested, RBI launched schemes intended to resolve stressed debt. Banks used these programmes to restructure their assets and avoid downgrading rather than recognizing their true quality. This favoured both banks and borrowers. Indeed, Vishwanathan has said that “early data shows that a large number of borrowers, even some highly rated ones, have failed on the one-day default norm”. This suggests that the magnitude of the problem of stressed assets in the banking system is underestimated.
Default is an important event. All stakeholders surrounding a defaulting company need to know that this has happened. Current and prospective employees, suppliers, lenders and shareholders may all change their decisions and beliefs about this company. Not disclosing the information creates an asymmetry between the immediate lender and everyone else. It is good news that RBI has dismantled older schemes that incentivized withholding information and brought in tougher regulation.
Under the regime imposed by the Indian Bankruptcy Code (IBC), firms are already liable if they default to operational creditors by just one day. The new regulations complement this framework. The one-day rule helps to identify distress early and to take corrective action rather than to kick the can down the road. Announcement of default will trigger early-stage work by potential bidders and improve the quality of work surrounding the corporate insolvency resolution process. Worries that this will put undue strain on the judicial system are unwarranted. Reducing information asymmetry by reporting stress as early as possible will help early resolution and lower the burden on courts.
Well-run firms have high-quality management and professional finance teams that ensure that payments happen without delay. They hold sufficient liquidity to ensure that cash flow issues do not hamper their ability to meet their deadlines. When a firm is slow to pay, it slows down everyone in its chain. Delayed payments clog up the entire system of credit.
RBI’s new regulations uphold the sanctity of the debt contract and provide the incentives needed to reform the poor credit culture in corporate India. These norms can have the positive network effect of aligning firms on to the path of paying dues on time. This will improve individual firms and the entire set of firms connected to them. The pressure exerted on firms through both the IBC and RBI will rightly push firms to higher levels of financial and operational performance.
Bahram Vakil and Kaushik Krishnan are, respectively, founding partner at AZB & Partners, and lawyer and economist at True North Managers LLP.