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Research World, Volume 12, 2015
Online Version


Article S12.4

Corporate Debt Restructuring and Bank Stability: Evidence From India

Mrigakshi Das, Subhendu Patnaik, T. K. Krishna Kumar, Vidya Pujari
Doctoral Candidates, Xavier University, Bhubaneswar, INDIA
mdas[at]stu.ximb.ac.in

Published Online: October 28, 2015


Note. This report is based on a seminar delivered by Sushanta Mallick, Professor of International Finance, School of Business and Management, Queen Mary University of London, UK, at Xavier Institute of Management, Xavier University, Bhubaneswar, India, on August 6, 2015.

Introduction

Banking regulators around the world aim at maintaining competition and stability in the banking sector. These are also the objectives of central banks such as the Reserve Bank of India (RBI). Since the year 2000, Indian corporates have faced increasing challenges in meeting their debt servicing obligations to banks and financial institutions. This posed a risk to banks’ balance sheets and their financial stability due to increasing non-performing loans and corporate bankruptcies. Similar situations have occurred in other emerging market economies too. Over the last two decades, banking systems in many emerging market economies have passed through major reforms including restructuring programmes, in the form of corporate debt restructuring (CDR) programme, to reduce bank-level non-performing assets. Debt restructuring refers to modifying the terms of a loan, so as to offer the debtor some opportunity to build up their debt servicing capacity.

The seminar focused on Ahamed and Mallick’s (2014) research that empirically investigated whether member banks benefitted from restructuring of corporate debts. Furthermore, their research also examined how the market power of banks influences their risk and whether CDR programmes reduce the risk of banks.

Corporate Debt Restructuring

During the late 1990s, Indian corporations encountered severe financial distress in terms of meeting repayment obligations. In this period the Indian credit market faced a downward spiral. To mitigate this problem RBI initiated a debt restructuring (CDR) mechanism in the year 2002. Prior to this CDR programme, the Board for Industrial and Financial Reconstruction (BIFR) was set up under the Sick Industrial Companies Act, 1985, to determine the sickness of industrial companies and to help entrepreneurs to rehabilitate economically feasible industrial units. BIFR was also the competent institution to dispose of economically infeasible industrial units. BIFR is an agency of the Government of India which functions similar to Chapter 11 of the United States Bankruptcy Code.

It was observed that there was misuse of the provisions of BIFR and it resulted in an increase of bad debt for financial institutions. To avoid such a problem, a new act was enacted: the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act). This new law allows financial institutions to confiscate the fixed assets of the borrowers without any meditation from the judicial system. Borrowers who are not eligible to get relief under the purview of BIFR regulations are automatically covered under the SARFAESI Act. However, most of the financial institutions offer initial relief to borrowers to restructure their loans (i.e., defer the repayment schedule) under the CDR programme. In the event of subsequent default, borrowers are invariably subjected to the provisions of the SARFAESI Act.

CDR is applicable with an exposure of Rs.100 million and above. As per the guidelines of RBI (2005) it is applicable to those financial institutions who have extended credit facilities under consortium / multiple banking / syndicate accounts. In such cases, decision for restructuring is contingent on gaining support from banks whose exposure on the loan value is 75% and 60% by number (Reserve Bank of India [RBI], 2005). Further, CDR is applicable to “standard” loan assets as well as “doubtful” loan assets, but does not include wilful defaulters (RBI, 2005).

Formulating Hypotheses

Degree of competition determines stability in the banking sector (Ahamed & Mallick, 2014). The first theoretical model proposed by Marcus (1984) depicts that competition in the deposit market prompts banks to adopt risky strategies. Such risky strategies are known as franchise value hypothesis. Study conducted on U.S. banking industry revealed that greater competition decreases the franchise value of banks and subsequently banks become prone to pursue excessive risky strategies (Keeley,1990). Furthermore, the proponents of “market power-stability” claim that banks operating on a less competitive environment tend to earn excessive profit and such profit accumulation provides a “buffer” against adversities. Beck (2008) emphasises that, during the said circumstances, banks are attracted to adopt excessive risky strategies. Therefore, Ahamed and Mallick (2014) proposed the following hypothesis:

Hypothesis 1. Market power effect can be positively associated with bank stability.

Ahamed and Mallick (2014) argue that banks are likely to increase their profitability “because of favourable regulatory forbearance on asset classification and provisioning as well as costs savings in managing non-performing loans” (p. 10). Accordingly, Ahamed and Mallick assume that member banks under the CDR system may increase their stability.

Hypothesis 2a. CDR can have a positive effect on stability of member banks.

Ahamed and Mallick are of the opinion that “alluded concessional loan loss provisions on restructured corporate loans have direct implications on the mark-up of the banks and their market power” (Ahamed & Mallick, 2014, p. 10). These authors note that “due to increasing market power, member banks may have shown delinquency in determining the riskiness of their portfolios” (Ahamed & Mallick, 2014, p. 10). Further, they point out that “since the aim of the financial reforms was to enhance market mechanism, transparency, and banking competition, we may expect an individual bank’s pricing power can channel through CDR and induce excessive risk-taking” (p. 10).Therefore, Ahamed and Mallick (2014) expected that CDR would influence an individual bank’s pricing power and accordingly, they formulated the following hypothesis:

Hypothesis 2b. The positive effect of CDR on stability reduces at higher degree of market power.

Methodology and Findings

Stochastic frontier analysis developed by Koetter, Kolari, and Spierdijk (2012) was used to estimate two measures of market power and interactive effect of CDR on bank stability. Further, to eliminate any sample selection bias, this study used alternative matching estimators developed by Abadie and Imbens (2006).

Ahamed and Mallick’s (2014) study found that the stability of the participating banks increased considerably after the implementation of the CDR programme. However, this study also observed that that CDR mechanism was found to be less effective beyond a threshold level of market power. This implies that even after implementing the CDR programme, stability of banks reduced with increase in the degree of market power. It was further observed that, with the second phase of deregulation, there was a significant positive effect on the overall stability of the Indian banking sector.

Conclusion

The result of this study indicates that after implementation of the CDR mechanism, stability of member banks increased by 43.6% (Ahamed & Mallik, 2014). The following issues were discussed after the result was presented in the seminar. It was pointed out that implementation of the CDR programme is not compulsory. In most cases, private banks in India do not extend facilities under the CDR mechanism; rather they invoke the provisions of the SARFAESI Act and undertake action to confiscate the collateral securities. Thereby they recover their legitimate dues. This led to a discussion on whether the study should have incorporated the effect of bank’s ownership (i.e., public sector versus private sector) in evaluating the impact of the CDR programme. Mallick clarified, the study was limited to banks that followed the CDR mechanism; therefore such a comparison could not be made.

References

Abadie, A., & Imbens, G. W. (2006). Large sample properties of matching estimators for average treatment effects. Econometrica, 74(1), 235-267.

Ahamed, M. M., & Mallick, S. (2014, June). Corporate debt restructuring, bank competition and stability: Evidence from India. Paper presented at the 6th International Finance and Banking Society (IFABS) Conference, June 18-20, Lisbon, Portugal.

Beck, T. (2008, July). Bank competition and financial stability: Friends or foes? (World Bank Policy Research Working Paper Series 4656). Retrieved from http://elibrary.worldbank.org/doi/abs/10.1596/1813-9450-4656

Marcus, A. J. (1984). Deregulation and bank financial policy. Journal of Banking & Finance, 8(4), 565-557.

Koetter, M., Kolari, J. W., & Spierdijk, L. (2012). Enjoying the quiet life under deregulation? Evidence from adjusted Lerner indices for US banks. Review of Economics and Statistics, 94(2), 462-480.

Keeley, M. C. (1990). Deposit insurance, risk, and market power in banking. The American Economic Review, 80(5), 1183-1200.

Reserve Bank of India. (2005, November 10). Revised guidelines on corporate debt restructuring (CDR) mechanism [Circular RBI/2005-06/206, DBOD No. BP.BC.45/21.04.132/2005-06]. Retrieved from https://rbi.org.in/scripts/NotificationUser.aspx?Id=2617&Mode=0



Suggested Citation: Das, M., Patnaik, S., Krishna Kumar, T. K., & Pujari, V. (2015). Corporate debt restructuring and bank stability: Evidence from India. Research World, 12, Article S12.4. Retrieved from http://www1.ximb.ac.in/RW.nsf/pages/S12.4




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