Is debt restructuring a moral hazard?

Thu, 11 Oct Pre-Open

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Chapter 11 is part of the US Bankruptcy Code. When a firm is unable to service debt or pay its creditors it usually puts its hands up and files for bankruptcy. This usually results in a reorganization of the debtor's business or personal assets and debts and can also be used as a mechanism for liquidation. If the stock is publically traded, equity shareholders are just left holding worthless pieces of paper. However in India, the corporate debt restructuring (CDR) process is voluntary and companies and shareholders enjoy better protection.

So what about the lenders (banks)? Aren't they stuck holding a can of worms? Well, according to rating agency Crisil, the estimated volume of loans to be restructured may jump 71% percent FY13 to Rs 2.05 trillion from Rs 1.2 trillion last year. This would translate to 5.7% of India's total bank loans restructured over the two-year period. The existing guidelines allow banks to restructure loans for debtors who don't have feasible plans to bolster their cash flows. Usually banks give borrowers a moratorium on payments, longer debt maturities or lower interest rates. But, rather than declaring certain assets as non-performing, lenders are just postponing the inevitable by agreeing to restructuring.

Now with more and more companies filing for CDR it will badly hit the balance sheets of banks. Borrowers such as Kingfisher Airlines may even default on the restructured debt as the economy slows and it faces a funding crunch. The current slowdown has led companies including GTL, Hotel Leelaventure, Hindustan Construction, 3I Infotech, KS Oils and Jindal Stainless Ltd. to tap India's voluntary debt-restructuring system. The CDR Cell received 433 requests for restructuring Rs 2.3 trillion in loans as of June 30 2012. This is more than double the Rs 958 bn seen in March, 2009.

Restructuring increases credit costs for lenders, which are required to set aside 2% of the value as provisions, compared with 0.4% for the original loan. New rules which are still under consideration by the Reserve Bank of India (RBI) propose for this to increase to 5%. The proposal also calls for introducing a limit on the amount of debt that can be swapped for equity in publicly traded companies. The promoters should also be required to contribute some amount towards the reduction of debt. These proposals are timely as banks are seeing a massive tidal wave of restructuring.

Fearing bad loans, banks may have agreed to the restructuring proposals way too easily. This may just have undermined the whole process and may be creating a moral hazard. Thus we welcome the RBI measures that make the process pinch a little bit more for both parties. But, we just hope that at least the big accounts which are already sick and under CDR don't turn septic.