What do we learn from the il&fs de­ba­cle?

A bill to pro­vide for fi­nan­cial res­o­lu­tion and de­posit in­sur­ance was with­drawn. The IL&FS de­ba­cle shows why we needed it

Governance Now - - CONTENTS - Joy­jayanti Chat­ter­jee

in their epony­mous book on debt crises, noted econ­o­mists car­men rein­hart and Ken­neth Ro­goff re­marked that the most dan­ger­ous words in any lan­guage are: “This time is dif­fer­ent.” The next most dan­ger­ous words, ac­cord­ing to dr raghu­ram ra­jan, ar­guably one of the best econ­o­mists of this gen­er­a­tion, are: “Next time will be dif­fer­ent”. In the light of re­cent events, noth­ing quite sums up the In­dian fi­nan­cial sec­tor as this sen­ti­ment.

in oc­to­ber, the gov­ern­ment of in­dia su­per­seded the board of the be­lea­guered in­fra­struc­ture Leas­ing & Fi­nan­cial ser­vices (il&fs) and ap­pointed a fresh board of di­rec­tors. This fol­lowed a se­ries of high-pro­file events ever since Life in­sur­ance cor­po­ra­tion was sum­moned to “take charge” of il&fs. The il&fs mess how­ever, has been long in the mak­ing. a pri­vate sec­tor en­tity with sig­nif­i­cant pub­lic sec­tor in­vest­ment, it has man­aged to es­cape over­sight of a sin­gle sec­tor reg­u­la­tor be­cause of its struc­ture. This is de­spite the fact that il&fs was des­ig­nated as a sys­tem­i­cally im­por­tant non-bank­ing fi­nan­cial com­pany (nbfc) by the re­serve Bank of in­dia. Lic’s tak­ing over the reins of il&fs came shortly af­ter its ac­qui­si­tion of a 51% eq­uity share in the trou­bled idbi Bank, which was way above the ex­ist­ing reg­u­la­tory thresh­old of 15% that could be ac­quired by an in­sur­ance com­pany in one sin­gle com­pany. The in­sur­ance reg­u­la­tor irda swiftly made an ex­cep­tion to al­low Lic to ac­quire the re­quired share in il&fs.

The nec­es­sary re­sources in both in­stances will come out of pol­i­cy­hold­ers’ funds or rather pub­lic money, mak­ing them noth­ing but ill-dis­guised gov­ern­ment bailouts for il&fs and idbi Bank. This fol­lows a re­cur­ring pat­tern of the tax-pay­ing pub­lic be­ing forced to bear the brunt of the mess cre­ated by er­rant banks and other fi­nan­cial in­sti­tu­tions. His­tor­i­cally eu­phemised as “manda­tory merg­ers”, such deals are a re­cur­ring trend in the In­dian fi­nan­cial sec­tor. rbi data re­veals that a ma­jor­ity of the bank merg­ers from 1969 (the land­mark year of bank na­tion­al­i­sa­tion) till date have been by way of a gov­ern­ment scheme where healthy trans­feree banks have as­sumed the full cost of the failed trans­feror bank. This re­peated re­liance on gov­ern­ment bailouts (di­rect or in­di­rect) cre­ates a sit­u­a­tion of im­mense moral haz­ard in the econ­omy. Fur­ther, from the per­spec­tive of the ac­quir­ing en­tity, it is tan­ta­mount to throw­ing good money af­ter bad, and their bal­ance sheet of­ten takes a se­vere

hit. in the longer run, this is of­ten an easy cop-out to gen­uinely con­fronting the prob­lems plagu­ing the failed fi­nan­cial in­sti­tu­tions, set­ting yet again, a poor prece­dent.

The il&fs deal, in par­tic­u­lar, has blown up into a prob­lem of gar­gan­tuan pro­por­tions. al­ready crip­pled by hu­mungous bad debts, ques­tion­able busi­ness prac­tices, and a con­vo­luted struc­ture, by septem­ber 2018, it started de­fault­ing on its pay­ment obli­ga­tions, trig­ger­ing a down­grade in its credit rat­ings, fi­nally lead­ing to the gov­ern­ment step­ping in to re­place the board of di­rec­tors. ac­cord­ing to uday Ko­tak, mem­ber of the new board, the sit­u­a­tion came per­ilously close to in­dia’s “Lehman mo­ment”. This serves as an omi­nous re­minder of the in­creas­ingly in­ter­con­nected na­ture of fi­nan­cial mar­kets, and the deep im­pacts shake­ups in one sec­tor can have on the en­tire econ­omy.

This begs the ques­tion whether there are other vi­able and work­able exit routes for dis­tressed fi­nan­cial in­sti­tu­tions other than messy gov­ern­ment bailouts. one of the most far-reach­ing con­se­quences of the 2008 fi­nan­cial cri­sis was the un­der­stand­ing that the one­size-fits-all for­mula sim­ply does not work when it comes to in­sol­vency pro­ceed­ings, lead­ing to a re­newed fo­cus on ex­plor­ing al­ter­na­tives to deal­ing with, or re­solv­ing, dis­tressed fi­nan­cial in­sti­tu­tions. The phi­los­o­phy which has been largely ac­cepted is that fi­nan­cial firms ¬do fail, and dis­tressed fi­nan­cial firms should be al­lowed to fail in an or­derly man­ner. There has also been a push for greater ac­count­abil­ity and trans­parency, es­pe­cially for sys­tem­i­cally im­por­tant fi­nan­cial in­sti­tu­tions.

since then, a lot of reg­u­la­tory at­ten­tion has been fo­cused on con­tain­ing the pos­si­ble spill-offs of fu­ture fi­nan­cial crises. in­ter­na­tional bod­ies such as the Fi­nan­cial sta­bil­ity Board (FSB) which was set up af­ter the g-20 sum­mit in 2009 pro­vided the guid­ance for this shift. In 2011, FSB pub­lished the ‘Key At­tributes of Ef­fec­tive Res­o­lu­tion Regimes for Fi­nan­cial in­sti­tu­tions’, which has served as the ba­sis of sev­eral over­hauls of res­o­lu­tion sys­tems across the world, in­clud­ing the dodd Frank act and re­lated reg­u­la­tions in the us, and in Hong Kong and sin­ga­pore in asia. These re­forms were based on the un­der­stand­ing that from time to time, fi­nan­cial in­sti­tu­tions will fail and the ne­ces­sity of ad­e­quate ex ante prepa­ra­tion for such even­tu­al­i­ties.

a re­view car­ried out in 2016

This re­peated re­liance on gov­ern­ment bailouts (di­rect or in­di­rect) cre­ates a sit­u­a­tion of im­mense moral haz­ard in the econ­omy. Fur­ther, from the per­spec­tive of the ac­quir­ing en­tity, it is tan­ta­mount to throw­ing good money af­ter bad, and their bal­ance sheet of­ten takes a se­vere hit.

re­vealed that in­dia com­plied with only four out of the 12 Key at­tributes. in or­der to fill this gap, the Fi­nan­cial Res­o­lu­tion and de­posit in­sur­ance (Frdi) bill was in­tro­duced in the in­dian par­lia­ment in the mon­soon ses­sion of 2017, only to be with­drawn scarcely a year later. a ma­jor rea­son for the de­ba­cle of the Frdi bill with­drawal is be­lieved to be the much ma­ligned and equally mis­un­der­stood ‘bail-in’ clause, which al­lows the con­ver­sion of debt into eq­uity in some spe­cific sit­u­a­tions. This pro­vi­sion has been made out to be a dra­co­nian mea­sure which will al­low the gov­ern­ment to re­sort to bank de­posits to save fail­ing banks. in re­al­ity, a host of checks and bal­ances (in­clud­ing an ex­plicit ex­cep­tion for bank de­pos­i­tors’ money) en­sure that bank de­posits sim­ply can­not be used at the whim and fancy of the gov­ern­ment to bail out failed fi­nan­cial in­sti­tu­tions.

it is also per­ti­nent to note that this was not the first in­stance of high­light­ing the need for such a law in in­dia. res­o­lu­tion as a func­tion sep­a­rate from reg­u­la­tion was recog­nised way back in the in­dia Fi­nan­cial code 2015 which it­self was based on the re­port of the Fi­nan­cial sec­tor Leg­isla­tive re­form com­mit­tee in 2013. The re­port of the com­mit­tee on Fi­nan­cial sec­tor re­forms (also known as the raghu­ram ra­jan re­port), in 2009, the re­port of the Work­ing group on res­o­lu­tion regime for Fi­nan­cial in­sti­tu­tions (rbi, Jan­uary 2014), and the re­port of the Bank­ruptcy Law re­forms com­mit­tee in 2014 have all un­equiv­o­cally called for a sep­a­rate res­o­lu­tion law in in­dia.

The cur­rent reg­u­la­tory mech­a­nism in in­dia is ill-equipped to deal with a large-scale fi­nan­cial dis­as­ter. Laws to deal with dis­tressed fi­nan­cial en­ti­ties are spread across a num­ber of laws, and are not uni­form for dif­fer­ent types of fi­nan­cial en­ti­ties such as banks, in­sur­ance com­pa­nies and nbfcs. Lack of an in­de­pen­dent spe­cialised body for res­o­lu­tion of­ten leads to sit­u­a­tions of turf wars among the var­i­ous ex­ist­ing reg­u­la­tors or worse, a de­lay in any mea­sures be­ing taken or reg­u­la­tory for­bear­ance. This can also be cat­e­gorised as ‘dis­as­ter my­opia’ or the ten­dency of agents to un­der­es­ti­mate the prob­a­bil­ity of ad­verse out­comes.

The sit­u­a­tion is all the more tricky when it comes to en­ti­ties which do not fol­low a clear reg­u­la­tory struc­ture and can os­ten­si­bly come un­der the tute­lage of two or more dif­fer­ent fi­nan­cial sec­tor reg­u­la­tors. The cu­ri­ous case of il&fs is a clas­sic ex­am­ple, which con­ve­niently fell within the gaps of reg­u­la­tory su­per­vi­sion. The Frdi bill as in­tro­duced in par­lia­ment would have ex­tended, among oth­ers, to all banks (in­clud­ing cer­tain co­op­er­a­tive banks), in­sur­ance com­pa­nies, sys­tem­i­cally im­por­tant fi­nan­cial in­sti­tu­tions, fi­nan­cial mar­ket in­fra­struc­tures, and cer­tain classes of de­posit-tak­ing nbfcs. in con­junc­tion with the in­sol­vency and Bank­ruptcy code, 2016 (which ap­plies to cor­po­ra­tions and in­di­vid­u­als), the Frdi bill was meant to pro­vide a com­pre­hen­sive in­sol­vency frame­work in in­dia.

in the post-2008 world, it is widely ac­cepted that the tra­di­tional meth­ods of in­sol­vency are se­verely in­ad­e­quate when it comes to deal­ing with the fail­ure of fi­nan­cial in­sti­tu­tions, es­pe­cially large and com­plex ones. The FRDI bill was an af­fir­ma­tion of this phi­los­o­phy. Mov­ing away from the ex­ten­sive re­liance on bailouts via tax­pay­ers’ money, it of­fered a num­ber of mod­ern, for­ward think­ing re­courses to the tra­di­tional meth­ods of in­sol­vency. it also re­lies ex­ten­sively on con­tin­u­ous su­per­vi­sion, con­tin­gency plan­ning, and tasks an in­de­pen­dent ex­pert body with deal­ing with the dis­tressed fi­nan­cial en­tity. All of these fac­tors would have al­lowed the res­o­lu­tion au­thor­ity to choose the best pos­si­ble method of res­o­lu­tion in a case-to-case ba­sis and have re­course to the nec­es­sary tools in or­der to cre­ate op­ti­mum value for all stake­hold­ers in­volved. The bill also pro­vided for a clear de­lin­eation of pow­ers be­tween the reg­u­la­tors and the res­o­lu­tion au­thor­ity, en­sur­ing that all non­con­flict­ing pow­ers of the reg­u­la­tors (in­clud­ing rbi’s Pca frame­work and con­sumer pro­tec­tion pow­ers) stay in force till the penul­ti­mate stage of fail­ure of the fi­nan­cial in­sti­tu­tion. As long as the fi­nan­cial in­sti­tu­tion would be in good health, the res­o­lu­tion au­thor­ity played no role, save min­i­mal su­per­vi­sory in­for­ma­tion col­lec­tion. in the longer run, the bill aimed to cre­ate a more sta­ble and re­silient fi­nan­cial sys­tem in in­dia.

The lat­est rbi Fi­nan­cial sta­bil­ity re­port, pub­lished in June 2018, points to the con­tin­u­ous rise of npas and the fall of gov­er­nance stan­dards a ma­jor con­cern. Weak prof­itabil­ity for banks, which is an­other is­sue that has been flagged can se­verely re­duce cush­ion for ad­verse shocks. Sig­nif­i­cantly, the re­port specif­i­cally men­tions the short­com­ings of fi­nan­cial cri­sis man­age­ment and a res­o­lu­tion mech­a­nism for sys­tem­i­cally im­por­tant fi­nan­cial in­sti­tu­tions, and sug­gests that a pre­ven­tion mech­a­nism can ar­rest the de­te­ri­o­ra­tion of a fi­nan­cial in­sti­tu­tion sig­nif­i­cantly.

Fi­nan­cial in­sti­tu­tions are not just the repos­i­to­ries of con­sumers’ money, but also of their trust. They have sev­eral char­ac­ter­is­tics which put them on a dif­fer­ent foot­ing from non-fi­nan­cial en­ti­ties like com­pa­nies and part­ner­ship firms. While some fi­nan­cial in­sti­tu­tions like banks, in­sur­ance com­pa­nies and pen­sion funds deal with sen­si­tive con­sumer de­posits, oth­ers like stock ex­changes and clear­ing cor­po­ra­tions are in­trin­sic to fi­nan­cial

The cur­rent reg­u­la­tory mech­a­nism in In­dia is ill-equipped to deal with a large-scale fi­nan­cial dis­as­ter. Laws to deal with dis­tressed fi­nan­cial en­ti­ties are spread across a num­ber of Acts, and are not uni­form for dif­fer­ent types of fi­nan­cial en­ti­ties such as banks, in­sur­ance com­pa­nies and NBFCS.

mar­kets. Fur­ther, be­cause of the in­creas­ingly in­ter­con­nected na­ture of the mod­ern fi­nan­cial sys­tem, a fail­ure in any one sec­tor tends to have a domino ef­fect, which can po­ten­tially rat­tle the en­tire econ­omy.

Had the Frdi bill been passed or a com­pre­hen­sive mech­a­nism for deal­ing with the fail­ure of fi­nan­cial in­sti­tu­tions ex­isted, the cur­rent sit­u­a­tion could have been dealt with in a much more el­e­gant fash­ion. and while the il&fs fi­asco has be­come em­blem­atic of the many woes of the In­dian fi­nan­cial sec­tor, it is only the tip of the ice­berg. as many as 11 of the 22 pub­lic sec­tor banks are cur­rently un­der rbi’s prompt cor­rec­tive ac­tion (Pca) frame­work. While the Frdi bill is by no means a magic so­lu­tion to the fi­nan­cial sec­tor’s woes, by its fo­cus on con­tin­u­ous su­per­vi­sion, a clear con­certed ef­fort on the part of the reg­u­la­tors and the res­o­lu­tion au­thor­ity, it cer­tainly was an at­tempt to tackle the very fac­tors which have been re­spon­si­ble for the mess in the first place.

a sys­temic risk sur­vey car­ried out by rbi from april to May 2018 to cap­ture the per­cep­tion of var­i­ous ex­perts (in­clud­ing mar­ket par­tic­i­pants, fi­nan­cial in­ter­me­di­aries, aca­demics, and rat­ing agen­cies) on the ma­jor risks fac­ing the fi­nan­cial sys­tem has flagged sev­eral telling is­sues. The like­li­hood of the oc­cur­rence of a high im­pact event in the global fi­nan­cial sys­tem and In­dian fi­nan­cial sys­tem in the short term was found to be ‘medium’. The re­spon­dents in the sur­vey also ex­pressed a sig­nif­i­cant de­cline in their con­fi­dence in the sta­bil­ity of the global fi­nan­cial sys­tem. The risk from ris­ing com­mod­ity (in­clud­ing crude oil) prices was iden­ti­fied as ‘high’ and the risk from po­lit­i­cal un­cer­tainty/pol­icy im­ple­men­ta­tion at ‘medium’ (a move from ‘low’ in the pre­vi­ous sur­vey).

a con­sen­sus is grad­u­ally build­ing up that the next fi­nan­cial cri­sis is a ques­tion of ‘when’ rather than ‘if’. JP Mor­gan has even put a date on the next fi­nan­cial cri­sis: 2020. While it’s easy to dis­miss these con­cerns as fear­mon­ger­ing, it should be borne in mind that Dr Ra­jan was (in)fa­mously scoffed at when he had pre­dicted in 2007 the last global fi­nan­cial cri­sis. This year has it­self seen a record num­ber of fi­nan­cial up­heavals, be it the re­peated bailouts of greece, the dra­matic crash of the Turk­ish Lira, or the ar­gen­tine cri­sis. The in­ter­na­tional Mone­tary Fund has warned that the next global fi­nan­cial cri­sis is not too far, and in its lat­est global fi­nan­cial sta­bil­ity re­port, has cau­tioned that “the fi­nan­cial sys­tem is per­ma­nently evolv­ing, and reg­u­la­tors and su­per­vi­sors must re­main vig­i­lant to this evo­lu­tion and ready to act if needed.”

Fac­tors like the rise of shadow bank­ing and in­ad­e­quate reg­u­la­tion and un­reg­u­lated parts of the econ­omy have been quoted as pos­si­ble rea­sons for the next fi­nan­cial cri­sis. In this con­text, it should also be borne in mind that il&fs’s shadow bank­ing ac­tiv­i­ties have been one of the ma­jor rea­sons be­hind its dra­matic fail­ure, turn­ing the fo­cus on many such nbfcs and hous­ing fi­nance com­pa­nies (HFCS) in In­dia. nbfcs have failed in in­dia with an alarm­ing fre­quency, jeop­ar­dis­ing the earn­ings of many or­di­nary ci­ti­zens. As re­cently as Feb­ru­ary 2018, the fi­nance min­istry re­leased a list of more than 9,000 high-risk nbfcs. in the wake of the il&fs de­ba­cle, there has been a flurry of NBFC li­cence can­cel­la­tion by the gov­ern­ment.

The irony of the with­drawal of a law which is geared to­wards deal­ing with po­ten­tial fi­nan­cial crises, in a year which marks the 10-year an­niver­sary of the global fi­nan­cial crash, should not be missed. The tim­ing of the with­drawal of the Frdi bill (un­easily close to the 2019 gen­eral elec­tions) is no co-in­ci­dence. Fi­nan­cial poli­cies of course are no stranger to par­ti­san pol­i­tics. Fol­low­ing one of his most prom­i­nent cam­paign prom­ises, don­ald Trump has ini­ti­ated the rolling-back of much of the obama-era dodd Frank reg­u­la­tions, which were fa­mously put in place af­ter the 2008 crash and aimed to in­tro­duce sweep­ing re­forms in the gov­er­nance and over­sight of the in­ter­con­nected fi­nan­cial sec­tor. This (mis)step is not only a leap back­wards, it is also likely to leave the in­dian fi­nan­cial sys­tem vul­ner­a­ble in the face of po­ten­tial fi­nan­cial crises. Ul­ti­mately, the harm caused by these stop-gap mea­sures will far out­weigh the short­term po­lit­i­cal and pop­ulist ad­van­tages gained by it.

Had the FRDI bill been passed or a com­pre­hen­sive mech­a­nism for deal­ing with the fail­ure of fi­nan­cial in­sti­tu­tions ex­isted, the cur­rent sit­u­a­tion could have been dealt with in a much more el­e­gant fash­ion. And while the IL&FS fi­asco has be­come em­blem­atic of the many woes of the In­dian fi­nan­cial sec­tor, it is only the tip of the ice­berg.

Photo: cour­tesy il&fs

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