IL&FS, termed by the Reserve Bank of India (RBI) as a ‘Systematically Important Non-Deposit taking Core Investment Company’, has default has caused immense panic in money markets and its ripples are being felt across the non-banking financial companies (NBFC) space as liquidity has virtual dried up.
This RBI definition of the company means that it is ‘too big to fail’ and the crisis emerging from its defaults have to be tackled or else it would snowball into a bigger issue that would surely impact the Indian economy on a broader level. The government, clearly aware of the situation, acted swiftly and superseded the board of IL&FS who are likely to make their first set of recommendations in a couple of days time.
The problems for IL&FS, however, are only beginning.
The enactment of the Insolvency and Bankruptcy Code (IBC) was one of the important reforms the country has seen in the past few years. The law provides for a clear and time-bound method to deal with corporate distress. It also provides for a clear course for the resolution professional to follow. The IBC law, however, is not applicable to financial firms. In fact, there is no law designed to deal with the insolvency or distress in financial sector firms. This is where resolving IL&FS crisis is going to be challenging as three kay issues emerge:
The IBC Law The first issue that the new board has to resolve is accountability of IL&FS. Should the company be run for its shareholders or debt holders? More importantly, who decides this? Does the new board decide this on its own or does the government lay down the mandate for the board? In the case of the IBC, it is very clear that the Insolvency Professional runs the company and effectively runs it for the financial creditors. The second issue is the timeframe to resolve the IL&FS crisis. If the new board acts fast, it runs the risk of selling assets at ‘distress’ valuations. And if it acts slow, it may realise better value but that prolonging the crisis might not be in the best interest of the creditors. The issue is exacerbated as there is no time frame laid down for the new board to resolve IL&FS crisis. This is in contrast with the IBC as the law provides for a fixed time to resolve the distress post which the company heads to liquidation. This allows everyone to effectively work backwards keeping the timeline in mind. The third issue: who absorbs the loss? Does the new board present the proposal as a fait accompli to certain classes of creditors or to the shareholders? Do the shareholders or creditors have any say in what the new board recommends? Will this get litigated? In the case of IBC, it is the Committee of Creditors (CoC) that decides who takes the haircut and by how much. Once the CoC decides with 75 percent majority, it is not subject to litigation. So, the CoC’s decision provides a sort of finality to the resolution process. FRDI Bill had the answers
The answers to all these questions and the framework to resolve IL&FS crisis would have been codified had the government passed the Financial Resolution and Deposit Insurance (FRDI) bill earlier this year.
The FRDI bill followed from the recommendations of the Financial Sector Legislative Reforms Commission (FSLRC) which was set up in 2011. This bill would have provided for a clear and timebound manner for resolving distress in financial firms. The FRDI bill had a provision for a Resolution Corporation (RC) made up of representatives from financial sector regulators, government and independent members. This RC would have had a maximum timeframe of two years to resolve the distress else liquidate the company. Simply put, the RC, as per this FRDI bill, would have taken charge of IL&FS and the decisions hence taken by the RC would not have been subject to any litigation providing finality to the resolution process.
Unfortunately, the ‘bail in’ clause in the FRDI bill sent jitters down depositors’ spines as concerns regarding safety of bank deposits led to panic withdrawals. The fears multiplied as depositors felt their money could be used to bail in banks. The finance ministry in January had said, ‘“Bail in has been proposed as one of the resolution tools in the event a financial firm is sought to be sustained by resolution.”
The FRDI bill, hence, was not passed. But we need the FRDI bill. We need a proper legal process to deal with distress among financial firms. The current ad-hoc process cannot continue.
Ashutosh Datar is a Mumbai-based independent economist.