India's crony capitalists are feeling the heat. Under new rules laid out by the central bank, lenders will be able to more easily take controlling equity stakes in failing companies. It is the boldest attempt yet by Governor Raghuram Rajan to ensure that powerful shareholders are the first to bear losses in a restructuring. It is necessary micro-management in India's skewed system of weak banks and too-powerful borrowers.
The notion that creditors rank ahead of equity investors in a winding up is a basic concept of modern capitalism. In India, however, tycoon shareholders have long used their influence to restructure loans without any intention of repaying banks, most of which are owned by taxpayers. That is why stressed credits still accounted for 10.6 per cent of the country's total banking assets as of March, according to rating agency ICRA. The problem is so bad that it threatens India's ability to finance any eventual pick-up in investment.
The Reserve Bank of India's new "Strategic Debt Restructuring Scheme" aims to redress the balance. It gives banks the option to convert all or part of their loan, plus interest, into a majority minimum 51 per cent shareholding if a borrower fails to meet restructuring milestones. The move, which needs the approval of 75 per cent of creditors by value, would convert the debt into equity at the market price or an adjusted book value. Lenders that end up in charge of listed companies also won't have to make a tender offer for the remaining shares.
That's a big improvement on existing mechanisms available to lenders beyond India's inefficient bankruptcy law. Under an existing Corporate Debt Restructuring Scheme that has been in place since around 2001, only about 15 per cent of the Rs 4 lakh crore ($63 billion) in bad debt has successfully been worked out.
Although the scheme is optional, banks will be under pressure to make use of it to avoid a repeat of disasters like the grounding of tycoon Vijay Mallya's Kingfisher Airlines in 2012. The rules will also tempt private equity players into making distressed investments. If Rajan's rules are fully embraced, India's crony capitalists will have had their day in the sun.
(The author is a Reuters Breakingviews columnist. The opinions expressed are her own.)