Covid-19 And The Ostrich School Of Risk ManagementBloombergQuintOpinion
The crisis-induced regulatory guidance on credit may have adverse side-effects.
In response to the economic crisis induced by Covid-19, the Reserve Bank of India, Securities Exchange Board of India, and the Insolvency and Bankruptcy Board of India have released several, well-intended regulatory guidelines. The clear intent has been to aid business borrowers navigate this period of extreme stress. While the underlying objective is to facilitate timely and low-cost access of credit to businesses and to rev up the economy in the post-coronavirus period, it also results in something else. Relaxations on debt servicing, bankruptcy filings, and reporting deadlines can have the outcome of filtering of important information on credit performance and credit quality.
Potential Unintended Consequences
Surely, the regulators are mindful of fact that Indian banks are not out of the previous non-performing asset crisis and the economy was in a downward trajectory before the coronavirus crisis. Guidelines such as the debt servicing moratorium will, at best, provide a short term reprieve. On the flip side, taken together, the current set of guidelines issued by several regulators may impact the credit culture to the extent that the ensuing information asymmetry may increase risk aversion among lenders. Besides, the overarching nature and limited specificity of the current guidelines and their interplay may prompt a small set of unscrupulous borrowers to game the system.
A surge in commercial lawsuits, reducing the efficacy of India’s nascent bankruptcy code in the ensuing two-three years may not be ruled out either. Corporates seeking stay orders against rating agency downgrades or seeking a stay on debt servicing could set very disturbing precedents.
If not handled promptly, this trend can potentially disrupt debt financing the same way as judiciary intervention had on the mining and telecom industries.
Given the nature of the epidemic, scenarios exist where substantial portions of the country may not return to normalcy even in June 2020. Even in places where the lockdown may be withdrawn, not all industries will bounce back immediately. Consumer non-discretionary and travel would likely be among the last to recover. In certain other sectors, the displacement of labour and muted consumer sentiment will impact businesses. One can also not rule out a second wave of the epidemic. Some of these scenarios playing out may result in an extension of some of the guidelines. If a new set of guidelines are to be created can we do better than the previous effort?
A Consolidated Regulatory Forum
Given the unprecedented scale of the current crisis and its evolving nature, it makes some sense if government policy is not shaped as a single 'bazooka fiscal package' issued at one go, but kept evolving as required. However, on the regulatory front, there's less room for rules to be issued in an ad hoc manner, with details of implementation following subsequently.
There is always an interplay among the guidelines issued by various regulators, and the regimes work best when laid out in coordination. During this crisis period, it makes sense to not only have enhanced coordination between regulators but also then see consolidated guidance issued from a single window. So forbearance guidelines related to bank loans and corporate debt should ideally come simultaneously from a joint forum of regulators. Such a forum could involve the Department of Financial Services, RBI, SEBI, IBBI, IRDA, and PFRDA.
The response to this crisis may call for some red lines to be crossed while others being re-written.
To control the spate of corporates seeking stay orders to delay debt payment, IRDA, PFRDA, and SEBI may guide respective institutional stakeholders to recognise the heightened risk of corporates who take the legal route at a time like this and keep that in mind for the future. Once the forum is formed, further guidelines can be evolved with lessons from the NPA crisis.
NPA Crisis Lessons
Regulatory forbearance typically does not improve the financial health of structurally-weak companies. Such companies ultimately sink, after accumulating higher debt. When they do end up in bankruptcy court, recovery is minimal. This is why the earlier a default is tagged, the quicker may be the viability assessment and higher the chance of an economically viable solution – of restructuring, sell-off, or liquidation.
This is not to say that given the systemic force majeure event that has occurred, businesses don’t need support. Will the resource constraints we face foist a forced-choice of who to assist – between companies that were stabler before this crisis and those that were structurally weak? The coronavirus has already subjected medical professionals to the harshest form of this choice – making triage calls directing care to some patients and not all, as hospitals in parts of the word were being overrun with Covid-19 cases. For businesses seeking aid, a crisis of solvency cannot be resolved by flooding with liquidity or time.
Conditional Differentiation Versus Blanket Benefits
There are borrowers whose credit profile was weak in December 2019. Some were already in what banks classify as Special Mention Accounts-2 even before lockdown started. Allowing a moratorium for such profiles may provide limited benefit. However, even among the solid companies from the pre-Covid era, several will be severely impacted by the lockdown may take at least two-three quarters to recover. If asked to make a choice, these are the business that should be the beneficiaries of regulatory forbearance.
RBI and SEBI could mandate borrowers with a bank loan rating or debt market instrument rating to share their financials, as of December 2019, with banks and rating agencies.
This would offer a view of the credit strength of the borrowers before the onset of the coronavirus crisis. Any subsequent deterioration which broke the trend may have been attributable to the crisis.
Regulatory Specificity Versus Opportunistic Interpretation
The valuers of debt paper and credit rating agencies have been asked to decide whether a default is due to the lockdown or not, which is a very subjective call. Such calls are also prone to manipulation and legal risk. One way to have made this less subjective would have been for SEBI to mandate a review be taken of companies as of their December 2019 position. Implementation details and differential treatment based on business viability will ensure that deserving companies get the required support at the same time the system is not gamed. That said, it is another matter whether regulatory-mandated divergence in the valuation of debt securities will at all improve confidence and liquidity in a bond market that is already struggling on both counts.
Lenders And Investors are Not Ostriches
Ostriches are, in popular popular imagination, assumed to manage a threat by filtering out adverse information, putting their heads in the sand. Distorting risk-related information and filtering out negative information causes lenders to lose confidence in the numbers. Their response has been to get even more risk-averse, which restricts credit flow to even otherwise worthy borrowers.
Hunting down information about defaults or digging up information about the extent of deterioration in the credit profile is part and parcel of the underwriter’s job. The external rating agency may get regulatory persuasion to provide a prompt upgrade but such maneuvers are unlikely to cut ice with a quality credit underwriter. Likewise, if a consortium of lenders is waiting for these six months to get over so it can take a borrower to bankruptcy court, those lenders are unlikely to take fresh exposure.
Even if the economy starts getting back on its feet by June 2020, which is an optimistic scenario, the fallout of these sub-optimal regulatory guidelines could start showing. To lessen that, any further regulatory support should be well-coordinated, detailed, and focused on economically-beneficial outcomes.
Deep Narayan Mukherjee is a financial services professional and a visiting faculty on risk management at Indian Institute of Management, Calcutta.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.