When a shadow bank is too indebted to fail (Mint)

• Mains Paper 3 : Economy
• Prelims level : DHFL’s insolvency resolution
• Mains level : Mechanism required to address ILandFS

Context

• India finds itself struggling to plug a hole in its shadow banking industry that gorged on lending to a real estate sector where buyers have turned tail. 

Failure of financial corporations:

• The Reserve Bank of India is expected to refer Dewan Housing Finance Corp. Ltd (DHFL) for insolvency proceedings that have been hastily tailored for financial companies. 
• India’s bankruptcy mechanism is missing vital components that it had agreed to put in place after the global financial crisis. 
• The government last year withdrew the Financial Resolution and Deposit Insurance Bill from Parliament after an outcry over a clause that would have let depositors’ money get converted into equity in the event of a bank or credit company turning insolvent. 
• The bill’s timing was unfortunate; it was tabled in the middle of a bad loan clean-up of state-owned banks, and fears of pensioners losing their life savings were easy to whip up. 
• Adequate deposit insurance was the solution, and the Centre has finally gotten around to it, now that the collapse of Punjab and Maharashtra Co-operative Bank has caused so much distress.

Question around DHFL’s insolvency resolution

• We have a system that can preserve value for creditors who have lent the company ₹84,000 crore.
• India may not have the legislative apparatus in place, but it knows what needs to be done with collapsing financial institutions. 
• The Group of 20 financial stability recommendations were based on the premise that the market, not the state, must address stress in the system. 
• We may not yet have an overarching body like the US Federal Deposit Insurance Corp., which can identify and resolve financial stress expeditiously, but its toolkit is divided among India’s central bank and other financial sector regulators. 

Validity of legal framework

• As for the legal framework, such cases can now be referred to the National Company Law Tribunal for resolution. 
• The courts could also back the claims of underinsured depositors. Earlier this month, India’s top court upheld the standard hierarchy of claims (with secured lenders first in line) in bankruptcy proceedings, another issue that had held up the resolution of such firms.

Significant challenges for DHFL

• Its loan book looks largely healthy, especially its mortgage lending section. Buyers have shown interest in these assets and the insolvency process is expected to draw more. 
• Bondholders and banks have their credit secured by underlying assets, although charges of fund diversion could diminish recovery. 
• KPMG, the audit firm appointed by creditors, has flagged fraudulent transactions that could add up to about half the exposure banks have to DHFL. 
• If these charges are substantiated, banks may have to write off their loans to the beleaguered mortgage lender, and it would complicate any resolution plan involving a swap of debt for equity. 

Way forward

• DHFL is being investigated by the Enforcement Directorate on charges that, if upheld, could result in the attachment of its assets. 
• This would make it tougher for resolution professionals to find buyers for DHFL’s healthy loan portfolio.
• If its insolvency resolution does run aground, India would have no option but to subject its shadow banking industry to the same mechanism until it can put a more robust process in place. 
• Credit rating agency Moody’s Investors Service has flagged stress among non-banking financial companies as a key risk to India’s growth outlook.

Online Coaching for UPSC PRE Exam

General Studies Pre. Cum Mains Study Materials

Prelims Questions: 

Q.1) With reference to the Credit ratings, consider the following statements:
1. It is assigned to debt instruments and equity instrument by a Credit Rating agency (CRA).
2. Credit rating agencies are regulated by SEBI under the SEBI (Credit Rating Agencies) Regulations, 1999.

Which of the statements given above are correct?

(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) None of the above

Ans: B

Mains Questions:
Q.1) What are the questions around DHFL’s insolvency resolution? What are the significant challenges for DHFL to revive?