Even as the Centre has temporarily suspended the Insolvency and Bankruptcy Code (IBC) due to the current economic crisis following the Covid-19 pandemic, academicians have highlighted the threat of a possible surge in riskier behaviour of firms under extended immunity from the IBC.

Earlier this month, the Centre had issued an ordinance to suspend initiation of fresh insolvency proceedings against defaults arising on or after March 25 for a period of one year. The decision came after the Finance Ministry expressed its intent to provide economic relief amid the Covid-induced economic crisis.

A new study by Prof. Balagopal Gopalakrishnan from IIM-Kozhikode and Professor Sanket Mohapatra from IIM-Ahmedabad reveals that although the IBC is suspended currently, “the insolvency reforms in India will have important implications for the corporate sector in a post-Covid scenario. While the suspension of IBC may be warranted in the current economic climate, a possible downside of suspending it for an extended period is that it could encourage riskier behaviour among firms.”

Notably, India had improved its world ranking in insolvency and bankruptcy after implementation of the IBC in 2016. India’s position in the World Bank’s ‘Resolving Insolvency’ ranking has increased sharply in recent years, from 132 in 2016, the year in which IBC was introduced, to 52 in 2020.

Moderation of adverse effects

Based on the data analysis of about 1,300 firms from 60 countries, the study reveals that countries that have stronger insolvency regimes are able to moderate the adverse effects of policy uncertainty and an economic crisis.

“In a stronger insolvency framework, where the promoters have a greater risk of losing control of the firm, the study finds that corporate managers are likely to be more conservative in their investment and financing decisions and, consequently, can reduce the risk of a debt default,” it said.

One of the arguments often advanced for implementing a stronger insolvency and bankruptcy framework is that it enhances credit discipline among firms. Using a large cross-country firm-level data set, the study empirically tests and confirms that a stronger insolvency regime moderates the adverse effects of economic shocks on firms’ default risk. The effects are more pronounced for firms in the top half of the size distribution.

The study also explores channels through which improved creditor rights influence firms’ default risk, including dependence on external finance, corporate leverage, and managerial ethics.