Identifying The Right Insolvency Framework For Financial Services Firms
Yesterday, the Central Government notified the rules for the resolution of systemically important financial institutions (SIFIs), other than banks. The specific SIFIs or categories of SIFIs that will be covered under the rules, have been left to further notification by the Central Government. The Government also declared that the ordinary provisions of the Insolvency and Bankruptcy Code, 2016 would be applicable to all other financial service providers who are not deemed systemically important.
Even before this notification, last week, the National Company Law Tribunal admitted an insolvency petition against Aviva Life Insurance, under the IBC. The NCLT's rationale for admitting the case was that because Aviva had defaulted on its landlord, an operational creditor, and not on a contract of insurance, Aviva cannot claim the benefit of the exemption for financial service providers under the IBC.
These developments beg the question whether the IBC process is suitable for the resolution of financial services firms. In this article, we argue that while the IBC framework works for most types of financial firms, it does not work for others such as banks, pension funds and insurance companies.
Limitations Of Collective Action - Based Resolution
First, the collective action process under a standard resolution framework does not work for financial service firms like banks, pension funds and insurance companies. The resolution process for a conventional firm is to allow creditors to co-ordinate and decide how value is to be realised from the assets of the firm, and to what extent different classes of creditors must take hair-cuts in settlement of their claims. This is a collective action process involving all the creditors. This process does not lend itself naturally to the resolution of banks and insurance companies because of structural differences in the the composition of their balance sheets.
The bulk of the liabilities of a bank are spread across a large number of depositors, and perhaps a few large institutional lenders. The costs of coordinating the collective action process of creditors like depositors of a bank or customers who have bought insurance policies, is huge. This is further compounded by the fact that coordination mechanisms, such as the appointment of trustees or agents to represent the will of these creditors, are not available in the case of depositors or insurance policy holders.
For insurance companies, the bulk of the liabilities are the current and future claims of insurance policy holders. These claims are contingent on the insured event taking place at some future date. At the point of insolvency, only those customers who have actual claims that have been filed are likely to be considered as creditors of the insurance company, while those whose claims are not fructified are likely to get excluded. This means that the creditors' committee of an insurance company may exclude a large proportion of the insurance company's customers. The creditors' committee of the company will then comprise of a very small group of its customers, who will decide the fate of a large group of contingent claim-holders. This creates a disparity in the treatment of creditors who are otherwise similarly placed contractually.
Asset Monetisation Could Cause Systemic Issues
On the asset side of their balance sheets, banks and insurance companies hold loans that they have made or investments in financial instruments such as shares and bonds. This makes them highly inter-connected with the financial system as well as the real economy. Subjecting such a portfolio to a standard resolution process, which seeks to monetise these assets in a short period of time, may have larger implications for the financial system and the economy. For example, one quick way to generate cash from a bank's portfolio of loans is to prematurely recall these loans. This, however, is likely to create stress for the borrowers of these loans, especially households and small and medium sized firms, who are financially constrained. It may cause further indebtedness of these borrowers at unfavourable terms as they attempt to re-finance such prepayment calls. It may even spark a wave of insolvency for such borrowers.
Similarly, when a large institutional investor, such as a bank or insurance firm, monetises its investment portfolio in a fire sale during a resolution process, it has implications for the price of the financial assets that are being sold, and for the financial market as a whole. A recent episode that demonstrates the challenges around the insolvency of a highly interconnected entity, was the sharp drop in the shares prices of several housing finance companies and non banking finance companies, in the wake of the default by IL&FS, despite these housing finance companies and NBFCs having little or no exposure to IL&FS. In fact, such fire sales by highly interconnected entities may cause wider distortions in the price of the financial assets that are sold, even though such distortion may have no linkages to the soundness of the underlying entities. In the extreme case, as was seen in the 2008 global finance crisis, the problems of a highly interconnected company such as AIG have the potential to trigger a panic in the entire financial system.
When The IBC Doesn’t Work
A creditor-driven, time-bound resolution process triggered by an actual default, does not lend itself to the resolution process of two types of financial firms.
- The first are firms that make high intensity long-term promises to their consumers, such as banks, insurance companies and pension funds.
A twenty-year insurance product works when a consumer believes that the insurance claim will be honoured over this period. A pension product works when the workforce believes that the pension fund will be around to honour their claims when they retire.
- The second are firms that undertake high levels of leverage based on a system of trust.
For instance, deposit holders rely on the promise that the money in their savings account will be repaid on demand. This happens despite the high levels of debt that banks take relative to their capital. To protect this trust, banks are subjected to intensive regulatory oversight, including the scope to make early regulatory intervention in times of financial stress. In the absence of such trust, financial intermediation will become costly, unless the trust-deficit is covered by a sovereign or equivalent guarantee. A classic example of this is the flight of capital to sovereign-backed institutions whenever there is stress in the financial system.
For the reasons explained above, most jurisdictions establish a separate resolution process for financial firms such as banks, pension funds and insurance companies.
Unlike the IBC, which is intended to be a market-determined, creditor driven process, the resolution process for these categories of financial firms involves early intervention by a financial sector regulator or the state.
In India, this mechanism is currently missing. The Financial Resolution and Deposit Insurance Bill, tabled in the Parliament in 2017, was intended to fill this gap. However, due to extensive protests by public sector banks and the media over the bail-in provisions, the bill became politically unpalatable and was shelved.
The arguments made above provide a clean framework for understanding the kinds of financial service firms for which a separate legal framework for resolution might be more appropriate than the IBC.
Clean Framework For Financial Service Firms Under IBC
First, the IBC-like framework is not suitable for financial service firms, which raise funds from retail sources, such as insurance customers, future pensioners or depositors, because of the high costs of coordination.
However, firms like NBFCs and HFCs, which fund themselves through wholesale sources and whose creditors are amenable to representation through an agent or trustee, might be well suited for an IBC-like resolution framework.
Such firms do pose the inter-connectedness challenge on their assets side, but these can be resolved by creating financial structures that reduce the possibility of premature loan recall.
Second, the IBC-framework is not suitable for financial service firms, such as banks, pension and insurance firms, that make long-term, high intensity promises to their consumers.
Third, the IBC-framework is suitable for financial services firms that are performing merely an advisory, custodianship or broking function. These firms, in our view, are entirely amendable to a resolution process of the kind codified in the IBC.
New Rules, New Confusion?
What are the immediate repurcussions of the developments of yesterday and the NCLT order in the Aviva Life Insurance case?
The NCLT has, in the Aviva Life Insurance case, declared a moratorium under the IBC. This means that Aviva may no longer be able to service its insurance customers as they would be construed financial creditors under the IBC. While the Ministry of Corporate Affairs rules, issued yesterday, explicitly and rightly keep banks out of the IBC ambit, they do not do so for insurance and pension firms. They also create tremendous uncertainty on the applicability of the IBC or the rules themselves to financial services firms, as the government and the regulator have been vested with extensive powers to notify and de-notify and trigger the insolvency of such firms.
The ideal solution would have been a first principles based framework, which makes a judicious and definitive choice on what insolvency rules would apply to financial services firms performing widely different functions.
However, in the absence of a first-principles based framework, the delegated legislation governing the applicability of the IBC to financial services firms will create an outcome that is fragmented and discretion-based. This would create a trust deficit of its own kind.
The authors are senior researchers at the Finance Research Group, at IGIDR, Mumbai.
The views expressed here are those of the authors and do not necessarily represent the views of Bloomberg Quint or its editorial team.