Bad loans: Prevention is better than cure

Source: Business Standard

Relevance: Issues related to banking sector in India

Synopsis: In managing the bad loan problem, IBC should be the last resort for banks.


The Standing Committee of Parliament attached to the Ministry of Finance has taken stock of The Insolvency and Bankruptcy Code and made suggestions for improvement.

Different models of insolvency resolution

There are two models for resolution of firm insolvency.

  1. One is the credit-in-possession model, which is the model in the UK, where control over stressed assets passes to creditors.
  2. The other is the debtor-in-possession model, which is the model in the US, where the debtor remains in control.

In India, creditors decide the future of an insolvent firm with the help of an administrator called the Resolution Professional (RP). The National Company Law Tribunal (NCLT) is the adjudicating authority.

Issues with insolvency process and suggestions 
  • Resolution Professional (RP): It turns out that the RP is a weak link in the chain. The Parliamentary Committee made critical observations on RPs. The regulatory authorities have pursued disciplinary actions against 123 RPs in a total of 203 inspections carried out so far.
    • Suggestion: The Committee wants a self-regulatory body to oversee professional standards for RPs akin to the Institute of Chartered Accountants of India.
  • Issues with NCLT: As for the NCLT, its processes are plagued by delays. There are delays of over 180 days in 71% of cases. One reason for that is, as in the judiciary, several positions on the NCLT bench remain unfilled. The NCLT is 34 members short of the sanctioned strength of 62 members. The longer the insolvency process takes, the lower will be the value that creditors will realize. Bidders will factor in the delays in the price they quote. Banks will end up losing as a result.
    • Suggestion: The Committee wants cases to be admitted within 30 days.
  • The Committee is concerned about the large haircuts (A haircut refers to the lower-than-market value placed on an asset being used as collateral for a loan) banks have taken in some cases
    • Suggestion: Setting up a benchmark or threshold haircut to be set.
  • It is more important to get the estimate of liquidation value right and to get as many parties to bid as possible. For this, it may be useful to create an Office of Independent Evaluation at the Insolvency and Bankruptcy Board of India (IBBI) similar to the one that obtains at the International Monetary Fund.
  • Revisit Clause 29 (A) (c): This clause bars promoters from bidding even if they are not wilful defaulters. It needs to be revisited. Where loans have gone bad for reasons beyond the control of promoters, it is worth giving them the opportunity to take part in the auction process under the IBC.
  • Extend pre-pack to corporations: The Committee suggests that the “pre-pack” format offered to micro, small and medium enterprises be extended to corporations.
    • In “pre-pack”, banks and the firm agree to a resolution before the case is referred to the NCLT. If banks and the firm can agree on a resolution, why go through the IBC process. The normal IBC process should be a last resort.
  • Improve risk management by banks: Lastly, risk management at banks needs to improve. It requires, among other things, considerable improvement in bank governance. The composition of boards, the selection of independent directors, compensation for independent directors (at public sector banks), the accountability of boards and other issues must be addressed. The RBI must press ahead with its recent efforts to overhaul board governance.

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