As I saw the details of the scheme announced by RBI to structure stressed assets in the Indian banking system, I recalled what I read in the May 2016 edition of the ‘Capital Markets Monitor’ of the Institute for International Finance on China’s equity for debt swap:
So far, the authorities have basically dealt with the debt problem by asking state-owned banks to evergreen the loans—the recently announced “debt for equity” swaps could be the ultimate evergreening if not accompanied by resolute measures to get rid of the excess capacity………
……… However, given the environment of slow growth amid collapsing productivity, such a strategy could instead lead to the scenario of Japan’s lost decade.
In a way, what the RBI had done with this one more ‘conversion to equity’ proposal, given the caveats that the scheme has built in, is to avoid coming to the central issue of ‘hair cuts’ – how much should the banks write off?
Mind you. This is not a criticism. The path to the first best solution/world from the status quo is not always a straight line. It is quite possible that RBI is coming (and bringing the rest of the society and the government) to that inevitable solution (haircut) in a slow and circular way, as is normal in all democratic and noisy societies. Building consensus takes an inordinately long time.
The so-called ‘ideal’ solution in my view is
- for banks to sell loans to ‘arms-length’ (completely unrelated) Asset Reconstruction Companies at a discount (hair cut);
- Regulatory, vigilance and other public audit companies approve the process and the method of arriving at the discount;
- Rights over collateral are transferred to the ARC. They deal with the borrowers. Hair cuts leave a hole in bank capital;
- Government merges some banks; changes management in many of them and starts privatising at least a few of them.