NBFC resolution: New IBC rules will bring some order

| Updated on November 20, 2019

A speedy resolution, which hasn’t been a hallmark of IBC cases so far, will be critical for financial firms

After the collapse of IL&FS last year led to defaults by a string of other non-bank financiers, there has been a felt need for a resolution mechanism for distressed financial firms. DHFL, for instance, has been muddling through a disorderly resolution, with lenders and the company pursuing parallel efforts at recovery and institutions skirmishing over collateral and haircuts, while retail investors have been left incommunicado. The Centre’s decision last Friday, to notify new rules under the Insolvency and Bankruptcy Code (IBC), that specify a resolution framework for systemically important financial service providers with assets of ₹500 crore or more, is a welcome step to bring some order to this chaos.

The resolution mechanism for financial firms will differ from that for other commercial entities on three counts. One, unlike other firms which can be referred to the IBC by their lenders or the firm itself, a financial firm can be referred to the IBC only by the appropriate regulator. This provision has perhaps been introduced to ensure that large financial firms, whose defaults can have a systemic impact, are not dragged to bankruptcy courts for frivolous reasons. But given that the very reference of a financial entity to the IBC can instantly undermine public confidence in it and often sound its death knell, the RBI would have its task cut out in deciding when to pull the trigger on a defaulting entity. Two, an administrator is to be appointed and a moratorium applied on all financial claims on the firm as soon as an IBC reference is made. Given that most financial firms are highly leveraged entities that can unravel pretty quickly, this is a necessary condition for orderly resolution. But this effectively means that once the entity is admitted to IBC, all its stakeholders, retail investors included, will have to hang on until a resolution plan is thrashed out. In the interim, as payments remain on hold, it is a moot point how regulators will contain the contagion effect on other lenders who have inter-linkages with the distressed firm. Three, while creditors enjoy carte blanche to decide on resolution or liquidation for other entities, for financial firms these will require regulatory approval. Given the systemic risk from a liquidation, regulators may prefer the takeover of such firms on an as-is-where-is basis. But financial firms thrive mainly on public trust and carry few tangible assets on their balance sheets, so finding interested buyers may not be easy. Overall, a speedy resolution, which hasn’t been a hallmark of IBC cases so far, will be critical for financial firms.

The even bigger lacuna in the new rules is that they apply only to non-bank entities and specifically exclude banks. With certain private corporate lenders tottering on the brink, and the PMC Bank debacle exposing the weaknesses of co-operative banks, a resolution mechanism for failing banks and a higher insurance cover for deposit-holders are today quite critical to shoring up public confidence in the financial system.

Published on November 20, 2019

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