In recent months, a landmark economic reform of the last decade has come under withering criticism from various quarters. The Insolvency and Bankruptcy Code (IBC), which was touted as a panacea to the debilitating problem of bad loans that had crippled the Indian financial system, has been attacked as being ineffective at best and counterproductive at worst. While vocal, rhetorical and political arguments have been made against the IBC on the basis of anecdotal evidence, a reform as radical and complex as this deserves a more objective and data-intensive evaluation.
The primary criticism against IBC has been on account of its allegedly paltry recoveries, which according to many critics makes IBC a legal mantelpiece instead of a powerful tool for economic value creation. Objectively speaking, this argument stands on several fragile assumptions. In any bankruptcy process, recoveries are impacted by a host of macroeconomic and firm-specific factors. This is because asset values are not constant and change according to the larger economic environment and competitive dynamics of the industry within which the firm operates. Therefore, to truly evaluate the IBC on recoveries, one would require a diversified data set spanning several industries and business cycles. Since such data is not available yet, an evaluation of the IBC on recoveries is likely to be biased. Even if one were to ignore this bias, its recoveries are not as dismal as they are made out to be. According to Reserve Bank of India (RBI) data, for the three years that IBC was used, recoveries averaged around 45%. Many have criticized the IBC by arbitrarily declaring this number as low. Some sell-side research firms have put forth an even more specious argument by stating that excluding top accounts, recoveries under IBC are 24%. Others have bizarrely cited individual cases where recoveries have been very low to declare that the Code has failed. These critics must be reminded that, in economics as in much of our lives, absolute numbers are meaningless, and every process has a distribution of outcomes which may be skewed, and cherry-picked anecdotes do not make a compelling argument. Recovery under the IBC can be evaluated only with respect to a benchmark. For robustness, we can use several benchmarks to evaluate recoveries under the IBC and arrive at a less biased estimate of its effectiveness.
One benchmark is the recovery proportion under alternate mechanisms. As RBI data shows, average recoveries for asset reconstruction companies (ARCs) under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act surpassed those under IBC just once in the 17-year period ended 2020, and have largely languished under 30% during this period. Similarly, Debt Recovery Tribunals surpassed the 45% recovery mark only thrice in this 17-year period and have been languishing with single digit recovery rates for the past few years. Therefore, to the extent that data is available, IBC recovery rates have not been abnormally low, but in fact higher than historical averages of alternate resolution mechanisms.
While it is true that there is wide variation in recovery rates among the sample, this is true for any bankruptcy process. Viral Acharya, Sreedhar Bharath and Anand Srinivasan (‘Does industry-wide distress affect defaulted firms? Evidence from creditor recoveries’, Journal of Financial Economics, 2007) find that for 1,511 US corporate bankruptcies between 1982 and 1999, the average recovery rate was 51.1% and the standard deviation of this rate was a large 36.6%, implying that there were many observations with extremely low as well as high recoveries, just as in the IBC’s case.
Similarly a comprehensive special report by Moody’s (‘Corporate Default and Recovery Rates’, 1920-2010) shows that the average recovery rate in US bankruptcies between 1982 and 2010 was 59.6% for first-lien bank loans, 27.9% for second-lien bank loans, 39.9% for unsecured bank loans, 49.1% for secured bonds, 37.4% for senior unsecured bonds and 25.3% for senior subordinated bonds. In the context of these numbers, the performance of the IBC, at least on the dimension of recovery, is quite impressive. Hawk-eyed sceptics will argue that recoveries for first-lien loans are much higher compared to the IBC, which exposes its ineffectiveness since all bankruptcies in India encompass bank loans. Such an argument ignores the fact that unlike the US, where banks are well informed and corporate bonds are subject to the discipline of free markets, most loans in India are issued by uninformed and poorly incentivized ‘sarkari’ bankers and the issuance of such loans often bears the stench of political influence and corruption. Many loans are secured on the ‘personal guarantees’ of promoters and are therefore unsecured for all practical purposes. Therefore many loans in India lose value at the time of disbursal and not due to the IBC at the time of recovery. Despite the value loss on issuance, on average, IBC recovery rates are comparable to those in the US bankruptcy process, long seen as the gold standard for this.
Thus, despite the limitations of recovery data, the censure and opprobrium that India’s IBC has been put to is completely unwarranted and misguided. In the second part of this article, I will discuss other criticisms of the law and explore a major gap in the IBC framework that must be filled to sharpen its effectiveness.
Diva Jain is director at Arrjavv and a ‘probabilist’ who researches and writes on behavioural finance and economics. Her Twitter handle is @Divajain2
