The Insolvency and Bankruptcy Code of 2016, was implemented by the Reserve Bank of India with a view to reduce the ever-increasing burden of stressed assets (Non-performing assets/bad loans) on commercial banks in the country. The impact of the policy in the overarching context of corporate governance (the process of banks monitoring how their loan amounts are used by borrowers) may be counterproductive. Its implementation has led to greater risks for businesses in terms of defaulting, which may act as a deterrent to innovation and productivity. Perhaps a more effective method of corporate governance would be enhanced monitoring of whom loans are given to, and how they are used, instead of whether they are repaid.
Before we delve into complex multifaceted issues like why the IBC was not effective, and what objective it aimed to achieve, let us understand what it is. The Insolvency and Bankruptcy Code of 2016 was implemented with a view to consolidate “the laws relating to reorganisation and insolvency resolution of corporate persons, partnership firms and individuals”. Further, it involved the establishment of the Bankruptcy Board of India which would oversee all matters relating to insolvency and bankruptcy of corporate entities (companies, limited liability partnerships etc.) The main objective of the law was to enhance and fasten the process of insolvency by (a.) bringing several different kinds of entities under the purview of the same law and (b.) establishing a framework which allows for economically viable solutions to the problem (something which was not really possible prior to its implementation). Here, we hope to evaluate how this policy factors into the objective of creating a more business conducive environment by reducing bureaucratic red tape and protecting the interests of small investors.
As per the code, the process of insolvency is now time-bound. Defaulting on repayment of loans by entities it is applicable to (and of amounts above the thresholds specified in the code), results in mandatory involvement of National Companies Law Tribunal (NCLT). The creditors and NCLT must resolve the issue within a stipulated time period. The entire process is handled by insolvency professionals appointed by the Board.
Why was the code necessary? Well, to answer that question let us consider the infamous case of Vijay Mallya; the business tycoon turned criminal on the run. Skipping over the details, the gist of the case involves questionable bank loans of large amounts being extended to Kingfisher when the company was already in debt, along with allegations of money laundering on the Chairman, Mallya. Ultimately, the company declared bankruptcy and Mallya fled the country. In the entire endeavour, innocent bystanders — small investors with a stake in the company — were the ones who truly lost out. The IBC aims to protect the interests of small investors and develop viable solutions to cases of bankruptcy/insolvency such as this one. It also aims at helping banks recover a larger proportion of bad loans. A lot of the need for such a law came from the alarmingly high level of Non-Performing Assets (NPAs) held by banks, among other factors like fraud and corruption.
Prior to the enactment of IBC, the average time taken to completely resolve the case of an insolvent entity took about 4.3 years. This is ridiculously high compared to countries like the UK (1 year) and the United States (1.5 years). The implementation of the code has brought this number down to 340 days according to an Economic Times Survey. Although on the surface of it, this would lead one to believe that the IBC has increased the efficiency of this process, and while this may be true, further analysis of the nature of resolution provides a more complex picture.
According to an article in the Business Standard, the statistics of insolvency cases since implementation of the code indicate that the increasing number of cases of insolvency are putting pressure on the IBC framework, and further, that the time stipulation is preventing effective and efficient outcomes from being reached. Failure to reach a resolution within 300 days, as directed by the code, has often led to the passing of orders for liquidation. About 56.17% of cases ended in liquidation (although a proportion of these were firms that were already out of operation). An article by Lexicology authors covers a different aspect of the IBC — its impact on the size of bad loans, and bad loans recovered. Theoretically, one would expect greater recovery due to implementation of IBC, since it has led to greater rates of liquidation than before, and that will obviously lead to a greater degree of repayment. This has been observed in practice as well, with Gross NPAs of scheduled commercial banks falling from INR 10,36,187 crores on March 31, 2018 (yes, you read that right) to INR 9,38,191 crores on March 31, 2019. This can largely be attributed to the efficiency of the resolution process (largely due to liquidation) under the code.
The code, by imposing such harsh penalties on individuals and firms for defaulting on loans, is aiming to ensure that loan amounts are used in an effective manner by debtors such that they can be repaid. Further, it is also aiming to enhance the functioning of banks by reducing the burden of stressed assets which may reduce their lending capacity. As we have elucidated above, the code has been extremely effective in achieving this particular target, as is measured by the reduced total Gross NPAs of commercial banks. However, the method in which this is achieved is extremely inefficient and fails to hold banks accountable for their inadequate effort in the process of allocating capital. Referring back to the case of Vjiay Mallya and Kingfisher, SBI led a consolidated case for loan defaulting against him along with several other banks. However, considering the financial state of Kingfisher at the time, I find it surprising that they managed to get a loan at all. Kolte et al. (2017) show how it was possible to predict the bankruptcy of Kingfisher using Altman’s Z score and Petrioski’s F score. However, just by considering the fact that Kingfisher has an extremely high debt capital ratio, and a fairly low-profit margin dealing with luxury air travel, it is not unreasonable to expect banks to be hesitant about giving INR 9000 Crore to Kingfisher.
Essentially the issue we are trying to shed light on is that of incompetency in capital allocation by banks. In cases such as this one, the bank should be held accountable by depositors and other stakeholders for poorly allocating capital in risky, non-lucrative avenues. The establishment of frameworks such as the IBC further encourages such behaviour by banks, by providing a safety net which will ensure recovery of some amount from debtors at the very least. So, it may further propound the problem of incompetency.
A last, concluding thought for the readers to consider: this policy may also discourage innovation and risk-taking behaviour from firms. Suppose a firm wishes to develop a new product which could potentially revolutionize a certain industry. For this, they require funds to invest into R&D. Fear of failure and the subsequent extreme penalty imposed under the IBC, may decentivize firms to undertake such ventures and stick to safer products.
Varun is a Third year Economics & Finance Major from Ashoka University.