Sanctity Of The Debt Contract And Tough Lessons For Indian Promoters And Lenders

“In much of the globe, when a large borrower defaults, he is contrite and desperate to show that the lender should continue to trust him with management of the enterprise. In India, too many large borrowers insist on their divine right to stay in control despite their unwillingness to put in new money.”

One of Raghuram Rajan's most impactful speeches as Reserve Bank of India governor continues to be his November 2014 talk titled, very simply, “Saving Credit”.

Delivering the lecture at the Institute of Rural Management, Rajan said “the flow of credit relies on the sanctity of the debt contract.” He added that the sanctity of the debt contract has been “continuously eroded in India in recent years, not by the small borrower but by the large borrower.”

The speech was followed by a grueling asset quality review in 2015, the underlying intent of which was precisely to correct the imbalance between lenders and large borrowers. It forced banks to recognise stressed assets and then proceed to resolve them. If that resolution, in turn, meant that promoters who didn't have the capacity to repay or recapitalise their businesses needed to lose control, then so be it. That intent was reinforced by the government which introduced a provision in India's insolvency law, which kept defaulting promoters out.

Friday marked an important milestone in that process with the Supreme Court of India clearing the decks for the takeover of Essar Steel by Arcelor Mittal.

Some Who Bore The Brunt

The Ruia family, soon-to-be erstwhile promoters of Essar Steel, are not alone in losing control of what was once a prized asset. The corporate debt clean-up, now into its fifth year, has left behind a number of casualties.

The Ruias have lost two key businesses in the process of trying to unwind the build-up of debt. They sold Essar Oil to Rosneft in a $12.9 billion deal in 2017 to help repay lenders. The also exited a smaller BPO business Aegis. They will now give up control of Essar Steel, with most legal options exhausted.

Tough lessons have been learnt by the Anil Ambani group too. Reliance Communications is undergoing insolvency and a number of other group companies are in default. To try and reduce debt, the group recently sold its once-prized asset management business to Nippon Life Insurance of Japan.

Venugopal Dhoot of the Videocon Group has also seen most of his businesses go into insolvency. That process of insolvency has also stretched out due to complex inter-linkages within the group, but Dhoot has made no bid to retain the businesses so far.

Manoj Gaur and the Jaiprakash Group are battling to retain control over their real estate business Jaypee Infratech Ltd., having already sold other core units including cement and some of their hydro-power plants. Earlier this month, the Supreme Court rejected a plea by the group to submit a resolution plan for Jaypee Infratech, perhaps paving the way for the Gaur family to lose control there as well.

There are others like the Singal family, which controlled Bhushan Steel Ltd. and Bhushan Power & Steel Ltd. through different family factions. Bhushan Steel has been sold to Tata Steel. The sale of Bhushan Power & Steel to the JSW Group has run into roadblocks due to investigations initiated into alleged money laundering and bank fraud.

This list is not exhaustive but illustrative of the fact that any perception of a ‘divine right to stay in control', as Rajan had termed it, has been shaken over the last few years.

Learnings For The System

But the idea was less about individuals and more about setting right some of the wrongs that had seeped into the system. How have we fared on that front?

It's a mixed bag. We have put in place some ingredients to move towards a safer lending system but others remain work in progress.

First, we now have a sector-wide database of large credits – the Central Repository of Information on Large Credits. Through this, banks can get a bird's eye view of the leverage that each large borrower is carrying on its books, unlike in previous years when there was incomplete information of who had borrowed what from which lender. While this is a good start, the CRILC needs to cover non-bank lenders and information from it needs to be available to the debt markets, perhaps via credit rating agencies.

A second important change that has been instituted is the large exposure framework, which kicked in fully starting this financial year. While banks had reduced concentration risk when the credit clean-up began, there was nothing to say they wouldn't go back to old habits if the tide turned. To prevent that, a large exposure framework limits a bank's total exposure to an individual borrower at 20 percent of its Tier-1 capital and at 25 percent for a group of connected entities, identified based on control and economic dependence. Increased provisions are required against incremental borrowings by large borrowers.

The first two measures are aimed at improving the flow of information and then putting some prudential limits in place. The next step is dealing with stress as it emerges.

For this, an early-warning system has been put in place through the “special mention accounts” categories, which club loans which are overdue but not yet tagged as non-performing. Banks are required to report these to the central bank as well, so, presumably, the regulator should be able to detect a build-up in system wide stress the next time around.

The last step—and one where the system continues to struggle the most—is that of quick resolution. The fact that we now have the Insolvency and Bankruptcy Code is undoubtedly a big step forward. But as the two-year-five-month long resolution process for Essar Steel proves, much needs to be done to quicken and streamline the process. Resolution outside the IBC, too, remains laborious and, in many cases, ineffective.

Rajan had closed his speech by saying: “We need a change in mindset, where the wilful or non-cooperative defaulter is not lionized as a captain of industry, but justly chastised as a freeloader on the hardworking people of this country.”

While we work on correctives within the system, has that mindset change happened? Maybe not. Are we closer to it? Perhaps.

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.