Too small to succeed Vs Too Big to fail

The Indian parliament took a giant step without much noise as it passed the Insolvency and Bankruptcy code a couple of weeks back. The attention for now has been to the bankruptcy that is looming in large and medium enterprises that which cripples lending activity of banks as a substantial chunk of the assets of the banks move to the ‘non-performing’ kind.

It is more of the creditors who are in the news, the public sector banks, not the debtors. But the code is about both these entities getting a quicker deal as the game must be both sided.

The game was never evenly poised as the ability to make an exit had a narrowly constricted window and depended a lot on the creditors’ resolve to stay with judicial procedures that could take five years on an average. The world on the other hand had better examples from Singapore to U.S., all getting a solution within a year.

The world on the other hand is busy taking down too big to fail institutions, those that make systemic risks rise to the hilt and without checks and balances it is to be expected that such institutions have internal mechanisms of weathering a storm instead of depending on bail outs with tax payer money. In India, we have the other side of the problem, we have institutions that are too small to succeed and we make systemic risks shrink so much that it impacts overall lending in many different ways.

Imagine in U.S. there has been a rise of 46% of bankruptcies in 2015 ($81 Billion in Publicly traded companies), owing much to the energy sector where prices have shrunk by 50% and there is no great noise about it. The size of this potential default dwarfs the size of assets locked in bankruptcy proceedings in India.

But in India the problem is with the public sector banks declaring 6% of their assets as ‘bad loans’, as reported by WSJ, hardly a denouement that can be easily ignored.

But the passing of the code, although a great positive step, must not just stop with the large corporates alone but do justice to the personal insolvency looming at large for many farmers in India; hundreds of poor farmers take to suicide as their only moral recourse when they become insolvent and that is where the true test should lie for this code. But we have a lot to progress on that account.

Are they too small to succeed? Would the insolvency code give them a lifeline to get back on track? These questions have remained largely unanswered.

Risk taking in India coincided with the emerging market growth fueled by the commodities upturn in recent times, but the capital allocation to certain sections of the hot economy was somewhat flawed, the pace of asset building in these sectors far outstripped the GDP growth and when the prices of commodities shrunk, some of the equities (including retained earnings) moved into negative territory. More than the sector, the individual stories were more like, “each unhappy family is unhappy in its own way”.

The overall bank lending in India has been weak by any standards, that too when interest rates have been clobbered down by the Reserve Bank and the overall direction of the rate has stayed in the drooping trajectory. With the banking system operating on very conservative instruments and every large investment going through a consortium of banks, the level of scrutiny has been far more stringent for defaults to happen. But it did, at least with public sector bank lending, and the provisions we see in the bank balance sheet is out in the open to see.

Recently Raghuram Rajan commented that India is insulated from a Lehman moment. He is very right, the system although it is weak to allow unlocking of value from a trapped investment, it does not allow the cascade of failed investments to proliferate through the system.  The reason however is that most of these failed investments remain stranded as risks do not move through the system. While this could be something very good for eliminating systemic risks, it does not say much how unbundling of risks has helped our system to function better. If that was so the world would have descended here to learn.

We therefore remain too small to succeed, while the world is scared about too big to fail institutions. The solutions have been prescribed for the latter in much detail, each Economist has differed from the other, but there is a general consensus on capital ratios and Tier 2 capital, those that have been prescribed by Basel III norms.

Much of this is about externalities, banks pushing their default risk to the other through instruments like CDS and the bundling of risk for the entire system, which is almost like a pollution hazard created by a particular industry on the environment, as an externality, whose price has to be paid by others not the industry.

Recently in a blog post Bernanke took us to some of the solutions for avoidance of failure of large banks, to which I have commented, “Dr. Bernanke is spot on with his comprehensive account; the internalizing of externalities, which takes the form of capital surcharge, the living will or the Pigouvian tax are the easiest methods that have been put in force. Perhaps with compensation schemes of managers that aim to defer payments over a longer period of time is a very effective method to keep things under check and act as the best incentives (or disincentives). However big banks of today are like inter-connected conglomerates, their businesses are too diverse across a plethora of products and services, but conjoined by risk; these have far more network complexities than we can think of, especially in the area of derivatives. A way to wall these network risks is something we must find a solution to.”

 

The banking system of ours will not benefit immensely from the bankruptcy code and its quicker implementation if we leave the woods for the trees, the treatment for the disease cannot be replaced by the faster application of the medicine. The disease for now is demand or the lack of effective demand which can only be improved through a plethora of things, but the most important is reforms. The growth in the infrastructure projects, which can be facilitated by the land bill, is one single biggest factor that would change the way things appear for now. The much hyped Seventh Pay Commission on the other hand has remained much muted in its scope. We must hope that we make some progress with Make in India, that which remains one big ticket waiting to be ticked off.

 

The plight of the farmer, those that are too small to succeed, remains to be fulfilled.