Skip to navigationSkip to content

India’s new bankruptcy code can’t fix its broken banks overnight

Reuters/Joshua Lott
It ain’t pretty.
Published Last updated This article is more than 2 years old.

There is all-round elation over the Lok Sabha’s passing of the Insolvency and Bankruptcy Code 2016 last week. The bill is expected to sail through the Rajya Sabha as well. This is a huge relief after the continuing impasse over the GST bill. However, there is a long way to go before the bankruptcy code begins to make a difference on the ground.

To start with the basics, the value of a firm is the total value of its debt and equity. When the value of a firm drops to the value of debt, equity reduces to zero, meaning the shareholders get wiped out. Thereafter, it is only the debtors or creditors who have a claim on the company’s assets. The bankruptcy process, which the bankruptcy code seeks to address, is all about how best can creditors recover their claims on a firm that has gone bankrupt. Think of the ongoing tussle between banks and Vijay Mallya in the Kingfisher Airlines case.

When a firm goes bankrupt, creditors need to make up their minds quickly on what to do with it.

There are different laws for different entities—a company, limited liability partnership, an individual, etc. This makes the task of creditors cumbersome.

They may judge that the firm has the potential to improve its performance. In that case, they can write off some of its debt and even provide further funding. They may do this by continuing with the existing management or by bringing in a new team. Or they may decide that there is no hope of recovery, in which case they must move quickly to liquidate the assets of the firm and recover whatever they can.

There are bankruptcy procedures in place at the moment. These, however, suffer from several infirmities.

One, there are different laws for different entities—a company, limited liability partnership, an individual, etc. This makes the task of creditors cumbersome. The bankruptcy code seeks to consolidate the existing framework and create a uniform institutional structure to deal with insolvency.

Two, it creates mechanisms that require speedy action on the part of debtors. Today, banks can wait for 90 days after default on payments in order to recognise an asset as a non-performing asset (NPA). Thereafter, they need to wait for 30 days before they can take action. The bankruptcy code allows creditors to recognise insolvency on the first date of default. Thereafter, the insolvency process has to be completed within 180 days, which can be extended by 90 days.

Three, today banks have every incentive to delay the insolvency process. The moment an asset is declared an NPA, banks have to make a provision for it and this erodes their profit. As a result, banks choose to delay the moment of reckoning—in the words of the Reserve Bank of India governor, they “extend and pretend” by making further loans to the borrower.

Today banks have every incentive to delay the insolvency process

By the time insolvency is recognised, the NPA is inflated in size, which means bigger losses for banks. The bankruptcy code seeks to reduce the discretion of the banks by interposing a trained Insolvency Professional (IP). The IP’s fee is linked to recovery, providing every incentive to expedite resolution and maximise recovery.

The IP is part of the new institutional structure proposed for bankruptcy. Other key features of the structure are:

  • Insolvency professional agencies that will train and certify IPs
  • Information utilities (IUs) that will collate and disseminate financial data on debtors
  • The Insolvency and Bankruptcy Board of India, a regulatory authority that will regulate and supervise the different entities created under the code
  • Two adjudicating authorities, one for companies and another for individuals and partnership firms.

The new architecture for bankruptcy, it should be apparent, has much to commend it. However, any celebration over the code would be premature. For a number of reasons.

One, the architecture will take a long time to evolve. The bill is not very clear on how the transition is to be handled. It does suggest that one of the financial regulators could take care of the regulatory functions until a separate board is in place. But it is silent on who can take the place of IPs and IUs until these are created.

Two, the code can do little to tackle the mountain of NPAs that banks are dealing with—it can at best address NPAs of the future. More importantly, it cannot address failings in public sector banks that come in the way of speedy resolution.

Loan restructuring requires banks to write off a portion in a given loan in order to facilitate revival. The biggest obstacle to speedy resolution today is that no banker in the public sector is willing to take a loss on a loan for fear of inviting action from investigating agencies.

No banker in the public sector is willing to take a loss on a loan for fear of inviting action from investigating agencies.

Then again, banks lack the expertise to replace the existing management with another one. Given these realities, it is not clear how banks can adhere to the 180-day timeframe for completing insolvency processes. The ministry of finance has proposed the creation of an independent authority to approve loan settlements. This will, perhaps, do more to expedite recovery than the provisions of the code.

Three, while the code lays down that no civil court will have jurisdiction in matters covered by the code, it does provide for Appellate Tribunals. Further, it allows for appeal in the supreme court against the tribunals on a matter of law. The present Debt Recovery Tribunals and Appellate Tribunals have been bogged down by the sheer number of cases. Moreover, firms can challenge their judgements in civil courts.

It certainly helps that resort to civil courts will no longer be possible. However, matters can still get clogged up at the Adjudicating Authorities and Appellate Tribunals themselves. For bankruptcy resolution to be effective, the administration and governance of adjudicating authorities and appellate tribunals need considerable improvement. Our record thus far offers little hope on this account.

📬 Kick off each morning with coffee and the Daily Brief (BYO coffee).

By providing your email, you agree to the Quartz Privacy Policy.