Does IBC work for financial firms?

The economy might be better off with a dedicated legal regime for the resolution of financial service providers and financial market infrastructure

Dewan Housing Finance Company Ltd. (DHFL) has become the first financial service provider (FSP) to undergo resolution under the new framework for FSPs. Regulated FSPs, such as banks, insurance companies, non-banking financial companies (NBFCs) etc. were initially kept outside the Insolvency and Bankruptcy Code, 2016 (IBC). It is evident from recent developments that the government has reconsidered this position. The IBC has been extended to NBFCs and housing finance companies (HFCs) with assets more than Rs 500 crore. Against this backdrop, it is worthwhile to understand why FSPs are unique and what could possibly go wrong if their resolution happens under the IBC in its current form. 

Various FSPs constitute the financial system. This financial system helps channel capital from savers to entrepreneurs for productive use. The failure of certain FSPs could reduce the aggregate capital available for productive use by entrepreneurs in an economy, seriously impairing economic growth. A problem of such magnitude is unlikely to arise due to the failure of any real sector company. This is a fundamental difference between FSPs and other real sector companies.

FSPs are of three broad types. First, some FSPs such as banks use their balance sheet to engage in liquidity transformation, maturity transformation and credit transformation. Similarly, FSPs such as insurance companies use their balance sheet to engage in risk transformation. These unique features make the business model of such FSPs extremely fragile. Moreover, such FSPs are usually highly interconnected with other such FSPs through their assets and liabilities. Insolvency of one might trigger a contagion across the financial system, jeopardising efficient allocation of capital across the economy. Evidently, these FSPs raise unique issues in insolvency. 

Second, certain FSPs are only service providers, such as the financial market infrastructure (FMIs). They may also face counter-party default risks. These risks are magnified if the pre-funded financial resources or liquidity arrangements to deal with default-related shortfalls prove insufficient. They also face operational risks. Materialisation of such risks could be devastating for systemically important FMIs. These may raise special concerns in insolvency. 

Third, some FSPs are pass-through entities such as mutual funds, brokers, pension funds etc. These FSPs pass investment risk through to their end-investors. Moreover, their client accounts are usually segregated from their proprietary account. Usually, they are not exposed to the balance-sheet risks discussed above. Only operational risks could push them into insolvency. Therefore, these FSPs usually do not raise any unique issue during insolvency.

A corporate insolvency law like IBC is ill-suited for FSPs of the first two categories. IBC is designed for value maximisation, not to promote financial stability. A judicially supervised public marketing process for an insolvent business may facilitate price discovery, maximising its value. However, such an elaborate process may be counter-productive to financial stability in the case of these FSPs, especially for systemically important financial institutions (SIFIs). Instead, a swifter resolution through a less transparent mechanism may be desirable. For instance, bank resolutions are typically executed by a regulator over a weekend. 

Moreover, a collective resolution process driven by a committee of creditors (CoC) is unsuitable for these FSPs. For instance, in the case of NBFCs, it is likely that the CoC would comprise of banks and other NBFCs that may often be competitors to the insolvent NBFC, creating perverse incentives at the time of voting. Also, coordination costs for retail depositors or insurance policyholders may be extremely high. Moreover, such creditors would be motivated by their immediate considerations and may not be concerned about financial stability. Therefore, the creditor-in-control regime under IBC is not designed to address financial stability concerns that arise during insolvency of these FSPs. 

Finally, under the IBC regime, resolution can be triggered only after a default. This arrangement may be fine for real sector companies. But for these FSPs, it may be useful to take corrective measures before they default. A default or even its mere possibility could cause a run on the FSPs with extremely short-term liabilities, which may put financial stability at risk. 

The special treatment needed for FSPs has been acknowledged by Indian policy-makers in the past. The Financial Resolution and Deposit Insurance (FRDI) Bill was introduced in Parliament in 2017 but was withdrawn. The FRDI Bill had proposed the creation of a separate resolution authority, which steps in at advanced stages of stress. The resolution authority was designed to swiftly and efficiently resolve the distressed FSP, and protect the interests of unsophisticated consumers. Policy-makers should consider reviving the FRDI Bill. In the long run, the Indian economy may be better off with a dedicated legal regime for the resolution of balance sheet-based FSPs and FMIs.  

(The authors are grateful to Sudarshan Sen & Prashant Saran)
 

Datta is a senior research fellow & Marwah is a research fellow at Shardul Amarchand Mangaldas & Co. Views are personal