New bankruptcy rules for financial services providers miss the big picture on reforms

Shohini Sengupta

Last week, the government notified rules for resolution of systemically important financial institutions (SIFIs), excluding banks, under Section 227 of the Insolvency and Bankruptcy Code, 2016 (IBC). It has been made clear that IBC’s regular provisions will be applicable to all other financial service providers (FSPs) not deemed SIFIs.

This piece, without getting into the specifics, will critique the policy prescription on the first principles of financial regulation, arguing that regulation of financial and non-financial firms cannot be clubbed. While excluding banks, the distinction between non-bank SIFIs and banks is an ill-considered move, and ignorant of the policy developments in the past decade.

Global financial crisis and the new order

In 2009, in the middle of the global financial crisis, the US Treasury released a new policy guidance to chart the future of financial regulation. A key recommendation was to evolve a new regime to resolve non-bank financial institutions whose failure could have serious systemic effects. This was directly in response to the crisis which demonstrated unequivocally that non-bank financial firms, in particular investment banks, insurance companies and large pension funds, had a unique ability to propagate systemic risk throughout the financial system.

As such, the US Congress created the Financial Stability Oversight Council (FSOC) and gave it two complementary tools to address non-bank systemic risk – first, an entity-based regulatory approach and second, an activities-based approach. In the former, the FSOC has the authority to designate an individual non-bank SIFI for enhanced regulation based on certain objective criteria, and in the later, the FSOC has the power to recommend that the primary financial regulatory agencies adopt “new or heightened standards or safeguards” for any financial activity that could propagate systemic risks.

It is important to understand that the new IBC rules, even while excluding banks, put non-bank SIFIs in virtually the same category as non-financial firms, ignoring some key insights from the financial crisis, which saw the failure of giant non-bank financial firms such as Lehman Brothers and AIG. It relies on a generalised regulatory framework that is unclear on its objective and operated in a non-transparent and unaccountable executive mechanism of cherry picking institutions for the IBC or off it.

Experts say a general bankruptcy proceeding works in most regular times. In stressed conditions, it may prove exceedingly difficult for distressed institutions to raise sufficient private capital. Thus, if a large non-bank financial firm fails during a financial crisis, India -- much like the US in 2008 -- will be left with two options – an ad hoc tax-funded government bailout which will create a moral hazard for financial firms, encouraging them to take more risks ex-ante (as in the case of AIG), and the application of ordinary insolvency laws, even with some streamlining, which may do too little to stop the spread of contagion (as in the case of Lehman Brothers).

Artificial Distinctions between SIFIs

For SIFIs, whether banks or non-bank financial institutions, the Financial Stability Board prescribes a specialized resolution framework, separate from an insolvency framework to fulfill three critical functions – first, allow orderly failure "without severe systemic disruption and without exposing taxpayers to loss"; second, ensure the continuity of critical functions of the institution, while protecting client funds and assets; third, ensure consumer protection, greater than that is envisaged in a general insolvency law.

The notified rules fail to capture these peculiarities of SIFI regulation. For one, barring the Financial Stability Development Council (FSDC), there is no body, policy prescription, or statute that currently details what is a SIFI, and which criteria would relegate a firm to be regarded as one. The process of designating a SIFI is unspecified (although individual regulators already have powers to prescribe a higher standard of micro-prudential regulation under their parent legislation), a power that will have to be crystallised for the Union government.

Lastly, there is no clarity on the appropriate remedy and appeal process available to the impugned firm, as a SIFI designation will bring up higher regulatory burden and costs.

More importantly, creating a distinction between bank and non-bank SIFI for regulatory framework is also ignorant of the interconnected financial system, where cross-sectoral spillovers are common, and a differential regulatory standard will only create moral hazard, public trust problems and system-wide externalities that will be subject to varied standards.

Furthermore, the IBC does not provide for critical function continuity, consumer protection and other safeguards simply because it’s never designed for financial firms.

To put this in perspective, in the event of failure of pension funds or insurance companies, there will be no continuity of critical services that are vital to economic function and consumer welfare. These are functions that help maintain financial stability and public trust in the financial system as a whole.

The legislative and regulatory intent to create a specialized framework for financial firms is abundantly clear from the Rajan Report of 2009, Report of the Financial Sector Legislative Reforms Committee in 2013, the Bankruptcy Law Reform Committee Report in 2015 and the Report of the Committee to Draft Code on Resolution of Financial Firms in 2016.

To ignore the history of financial regulation and the learning of the past decade is both counter-productive and dangerous.  Creating interim measures without adequate public consultation and foresight is in itself symbolic of a struggling legislative system that relies on hastily drafted stop-gap arrangements to further short-term political wins.

Shohini Sengupta is a policy lawyer based in Delhi. She tweets at @shohinisengupta. Views are personal.