Bhargavi Zaveri & Shivangi Tyagi: Missing pieces in the Bankruptcy Code

The move to keep the entire financial services sector out of the Code is misplaced and must be revisited

The draft Insolvency and Bankruptcy Code (hereafter called the Code) has been projected as one of the biggest reforms proposed by the National Democratic Alliance government. A significant change is the promise of a consolidated legal framework for the bankruptcy of all entities. Today, the rules in India governing bankruptcy depend on whether the debtor is a company, an individual, an LLP (limited liability partnership) or a partnership firm. To this extent, the Code provides a clean break from the past.

However, it leaves out an important sector of the Indian economy - the financial services sector. The Code, in its current form, does not govern the insolvency of banks and other financial firms. This means the creditors of banks, insurance companies, financial markets infrastructure (such as depositories and exchanges), funds, brokers and all entities regulated by the financial regulators, will continue to rely on the existing insolvency framework when such firms default on their debt. Such a blanket exclusion of all financial firms from the Code is misplaced and must be revisited.

Conventionally, banks and insurance companies have been kept out of the standard bankruptcy process applicable to other firms in an economy. Globally, too, there is a divide on the bankruptcy processes applicable to banks and financial institutions on the one hand, and non-financial firms on the other. This divide is fostered by several factors. First, firms which accept deposits from the public have a unique class of consumer-creditors whose interests cannot be fully protected under the regular bankruptcy process. This problem is exacerbated where the deposits are insured by the state or its agencies. Second, some kinds of financial firms, such as insurance companies and pension funds, make long-term promises to their consumers. The liquidation of such firms can be highly disruptive for households and potentially have an adverse impact on the economy as a whole. Third, the size and inter-connectedness of financial firms with the rest of the economy may make them systemically important, thereby warranting special treatment in case of bankruptcy.

Financial firms, which display any of these three characteristics, necessitate a separate treatment that allows early intervention before they are actually bankrupt. The bankruptcy process for such firms must support a mechanism for smooth and efficient transition of their businesses without disrupting their services. For instance, banks and insurance companies in the United States are not covered by the US Bankruptcy Code; they are governed by special resolution regimes. Similarly, in 2009, the UK enacted a special resolution regime for banks in the country. Post the global financial crisis, special resolution regimes for large financial institutions have been enacted across the developed world.

The Code, as currently drafted, empowers the central government to notify the financial firms that will be governed by it, in consultation with financial sector regulators. However, this creates more problems than it solves. First, it introduces uncertainty in the rules that would be applicable where a creditor of a financial firm is faced with a default. Second, the insolvency of financial firms - which do not have the special characteristics mentioned before - must be governed by the same rules applicable to non-financial firms. Hence, unless they are systemically important, the bankruptcy processes of brokerages, asset managers, merchant banks and financial advisors must be governed by the Code. The rights of their creditors are not different from the those of the creditors of non-financial firms in any way. Where these firms hold money in trust for their clients, such money is bankruptcy-remote.

For Indian financial firms, which are deposit-taking or systemically important, the reform in the Code must be complemented with a parallel specialised resolution regime. Such a regime will allow them to be wound up before they are insolvent, and transition their businesses to healthy firms without disrupting the economy. This recommendation has been made by the Financial Sector Legislative Reforms Commission (FSLRC) as well as a Working Group on resolution co-chaired by the Ministry of Finance and the Reserve Bank of India.

By leaving out the entire financial sector, the bankruptcy reforms deprive the creditors of financial firms of the efficiencies that they promise to bring. The insolvency of financial firms will continue to be long-drawn-out and problematic. The Code is one shot at deep reform of bankruptcy processes and infrastructure. Even as we debate on the solvency status of Indian banks and procrastinate on structural reforms proposed by the FLSRC, we must make sure that the bankruptcy reform is comprehensive.

The authors work with the National Institute of Public Finance and Policy