Home / Opinion / The RBI’s harsh prescription

In a press release issued on 13 June by the Reserve Bank of India (RBI) wherein 12 accounts for reference under Insolvency and Bankruptcy Code were cited, it was also mentioned that RBI will notify revised provisioning norms for cases accepted under the code. Certain newspapers have recently reported that RBI has mandated banks to set aside at least 50% of the loan amount as probable losses for cases referred under the code. These reports also suggest that the RBI has directed a provisioning of 100% of the loan amount for cases that are not resolved in the initial period of 180 days.

If these reports are indeed true, the RBI has probably erred on the side of caution. There is limited or no empirical basis available in the public domain to justify the “zero recovery" assumption envisaged by the RBI. In addition, the RBI’s assumption regarding the final resolution timeline of 180 days is quite aggressive and does not align with the findings based on the experience of developed countries.

In a speech delivered on 15 September 2015, then deputy governor of RBI, R. Gandhi, pegged the average recovery rate on assets sold by banks to reconstruction companies at 31%. He also cautioned that the low recovery rate may be biased by the fact that a substantial part of the assets under management of reconstruction companies was acquired recently. An Ernst & Young report commissioned in 2016 by the Associated Chamber of Commerce & Industry of India estimates recovery rate for reconstruction companies in a similar range at 30%. The data available on the impact of the regulatory framework on institutional capacity, insolvency timelines and recovery percentage in India is limited. My empirical study—based on the RBI statistical tables—for a three-year period (2012-2015) involving more than 1.6 million insolvency cases administered through the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, indicates a recovery percentage of 25%. Even under the much-criticized Recovery of Debts Due to Banks and Financial Institutions Act, 1993, the recovery percentage of cases adjudicated by DRTs (debt recovery tribunals) was 16%.

In light of these empirical observations, RBI’s assumption of zero recovery is indeed harsh. The equity markets also appear to diverge from the RBI view. Out of the eight firms that have been referred to the National Company Law Tribunal, seven are listed on the stock exchanges. The stockholders will not have any claim on residual assets unless banks are paid in full or debts are settled at an agreed haircut. But many of these firms are trading at valuations that are definitely not insignificant and are much in excess of the option value. The equity market view indicates that either the bank will be paid in full or some amicable settlement will be structured between both parties.

The Indian Insolvency and Bankruptcy Code, 2016 has been modelled on the lines of Title 11 of the United States Code. An analysis of empirical findings on bankruptcy timelines in the US indicates that a timeframe of six months is inadequate to prepare a robust revival plan which can be agreed upon by a super-majority of creditors. Stuart Gilson, John Kose and Larry Lang analysed a sample of 89 firms listed on the NYSE and AMEX stock exchanges that entered Chapter 11 bankruptcy between 1978 and 1989. They found that the average time spent in reorganization was approximately 20 months. In addition, firms spent an average of eight months in pre-chapter 11 negotiations.

Arindam Bandopadhyaya studied firms that entered into Chapter 11 protection in the US between 1979 and 1990. His findings, based on a study of 74 firms where 43 firms exited the Chapter 11 process, showed that the average time spent by these 43 firms was 854 days. He also concluded that as time spent by a company under Chapter 11 increases, so does the probability of a successful exit. Similar empirical findings on the bankruptcy timeline were reported by the research of R. Barniv, A. Agarwal and R. Leach in their 2002 paper, Predicting Bankruptcy Resolution, as well as that of Kai Li.

Even in the US with experience of over 30 years in managing economic, harmonization and legislative challenges involved in the bankruptcy process, a six-month deadline to complete the insolvency process would be considered impracticable. Therefore, RBI’s insistence on full provisioning after six months is punitive and will probably lead to a hastily arranged liquidation process. An assumption that a competitive auction will inevitably result in a firm to be sold at the highest price is true only in a certain context. The auction mechanism works well if raising cash for bids is easy and there is plenty of competition among several well-informed bidders. These conditions are often not met even in the advanced Western economies and are less likely to be satisfied in bank-oriented economies like India. In a fire-sale liquidation scenario, the residual value will be appropriated by vulture firms from banks. In the case of public sector banks, taxpayers will be the ultimate sufferers.

The RBI directive in its current form will lead to an undervaluation of assets on bank balance sheets. Banks in India are already challenged in their ability to raise additional equity from private players. The implementation of the RBI directive will further aggravate the situation and render banks reliant upon equity infusion by the government.

The RBI should consider amending the directives and specify provisioning norms that are aligned with the historical recovery rate. An acceleration of provisioning after six months to a zero book value should be replaced by a provisioning amount that conforms to the National Company Law Tribunal appointed liquidator’s appraisal value. This will prevent fire-sale liquidation and promote bids for assets that preserve “going concern" valuations.

Ashish Pandey is the founder and managing partner of Quadrature Management LLP. Comments are welcome at theirview@livemint.com

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