The stock market reaction to the Banking Regulation (Amendment) Ordinance, 2017 has been positive for banks and their high-quality borrowers but negative for distressed firms, suggestive of its potential to rejuvenate the banking sector’s health and improve capital allocation across firms, according to a study put together by researchers with the Centre for Advanced Financial Research and Learning (CAFRAL).

The study found that cumulative abnormal returns (defined as the difference between realised returns and expected returns) of stressed banks increased sharply following the Finance Minister’s April 24 announcement of empowering the central bank to address the problem of non-performing assets (NPAs) in the Indian banking system.

“This pattern continues till the event date, which is the date of promulgation of the ordinance (May 4). In contrast, non-stressed banks witnessed a more modest increase in abnormal returns,” it added.

Strikingly, according to the study, abnormal returns between stressed and non-stressed banks widened to almost 5 per cent between the time of the Finance Minister’s announcement and promulgation of the ordinance, indicating that markets perceived the ordinance would help the stressed banks in resolving their NPA problem.

The ordinance empowered the RBI to direct banking companies to initiate insolvency proceedings in respect of a default under the provisions of the Insolvency and Bankruptcy Code, 2016 (IBC). It also enabled the RBI to constitute committee(s) to advise banking companies on resolution of stressed assets.

In the wake of the ordinance, an Internal Advisory Committee (IAC) constituted by the RBI held its first meeting on June 12, 2017. The IAC recommended that all accounts with outstanding amounts greater than ₹5,000 crore, and with more than 60 per cent classified as non-performing by banks (as on March 31, 2016) would qualify for reference under the Insolvency and Bankruptcy Code (IBC).

Using this criteria, 12 accounts aggregating around 25 per cent of the current gross NPAs were identified and banks were directed to file for insolvency proceedings under the IBC in respect of these accounts.

CAFRAL is an independent body set up by the Reserve Bank of India for policy research and advanced learning in banking and finance.

According to the study, low-quality firms linked to stressed banks performed worse than low-quality firms linked to non-stressed banks. In contrast, high-quality firms linked to stressed banks performed better than high-quality firms linked to non-stressed banks, at least in the days immediately following the event date.

“It appears, therefore, that the market lost confidence in low-quality firms linked to stressed banks but high-quality firms linked to stressed banks are seen in positive light.

“One possible explanation for this is that high-quality firms linked to stressed banks benefit from a balance sheet clean-up of stressed banks. The market may also be reflecting long-term benefits to high-quality firms, possibly through the reallocation of resources away from low-quality firms,” it said.

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