Thursday, November 23, 2017

Don't rush to ban promoters from the IBC process

There is speculation that the Government will amend the Insolvency and Bankruptcy Code to prohibit promoters from bidding on their firms in the insolvency process. This is to avoid letting owners of an insolvent firm effectively repurchase their firm or its assets at a discount after shedding debts that the firm had incurred under their control. The objective is to also ensure that lenders do not persist with ever-greening their loans when there may be no collective financial justification for doing so.

We appreciate the appeal of such a rule, especially when cases of dramatic promoter malfeasance and mismanagement, and ever-greening of loans by banks are fresh in our minds and all too common. But we worry that the change proposed by the Government would sacrifice potentially beneficial aspects of the Code to avoid something that can be dealt with through more modest reforms, some of which can be done through regulations and would not require reform of the Code. In fact, the Insolvency and Bankruptcy Board of India (IBBI) has already taken the step of amending its rules to ensure that promoters proposing turnaround plans for their sinking companies will be subjected to a stringent test of creditworthiness and credibility.

All promoters are not the same

It is true that promoters who run their businesses into the ditch through fraud or mismanagement should probably not be able to employ the IBC in concert with aligned creditors to simply shed their obligations and continue on their merry way. But many firms run by honest and competent promoters end up in
financial distress due to factors beyond their control or that they could not reasonably be expected to have anticipated. Others will have made avoidable but forgivable mistakes.

The Code makes it very easy to force such firms into insolvency - a single default on a single debt suffices. In such an event, scrupulous and competent promoters may get permanently excluded from participating in their firms going forward if the reform under consideration is adopted. This might disincentivise good promoters from entering into businesses in the first place or from borrowing in arms-length transactions, either of which would impede the culture of entrepreneurship and the environment for start-ups that the government wishes to encourage.

This has consequences for the broader system

If this were only a question of the potentially harsh treatment of those promoters who are neither incompetent nor unscrupulous, we might consider that this could be an unfortunate but necessary aspect of the new insolvency and bankruptcy system. Law often imposes some unpleasantness in the service of avoiding greater harm.

But excluding such promoters from their reorganized firms will
predictably externalize losses on others and on the broader system. Promoters are often in the best position to turn their firms around, and occasionally they are essential to that outcome. In other words, excluding promoters from the process will make it harder to reorganize some firms that have experienced insolvency or financial distress, something that is hard enough to do with access to all available human resources.

Perhaps even worse, in a situation where creditors themselves
prefer to have the promoters continue to be involved with a firm that is in financial distress, they might avoid using the new insolvency system at all, or dismiss cases strategically, undermining the scope and effectiveness of the new Code.

Potential solutions

A rule excluding promoters from potential bidders in the insolvency process is not even necessary to achieve its purpose of protecting the system from unscrupulous or incompetent promoters. If the concern is that some promoters will effectively collude with creditors to take advantage of the new system to take their firms back after shedding debts, or that the inclusion of promoters in the bidding process will discourage or scare away other potential bidders, there are other ways of addressing such threats.

The US bankruptcy system, for example, has addressed this problem by allowing preexisting shareholders to have a stake in a reorganized firm if they put in new value equivalent to their new stake and if the reorganization plan was open to other potential bidders. Additionally, if a class of creditors objects to the plan, the presiding bankruptcy court must determine that the reorganization plan involving the preexisting shareholder is neither unfair nor discriminatory to the objecting class. These rules are not without controversy in the US, but they reflect a reasonable approach to constraining shareholders' participating in reorganized firms without banning them from doing so altogether.

Protections of this kind could easily be incorporated into India's new insolvency and bankruptcy system. Promoters could be allowed to submit bids, for example, only if an independent resolution professional is assigned to the case by the Insolvency and Bankruptcy Board. The resolution professional and the NCLT could be required to ensure that the promoters put up new value equivalent to their stake in the reorganized firm and strictly review other aspects of the resolution plan and the process of its approval by the creditors committee.


The new Code was designed to give creditors significantly more
power in relation to their debtors in deciding when to initiate
insolvency cases and what happens to debtors within the system. This system is thus built on the logic that creditors as a group know what is in their best interest and that it is possible to protect smaller creditors in the process. If policymakers are not comfortable letting creditors decide whether the promoters should participate in their reorganized firms, this suggests a lack of confidence in the new system and the various actors and institutions that operate it.

To date, the new system has performed surprisingly well, given the huge challenges that faced it upon inception. It seems too early to let a lack of confidence erode the basic approach and potentially undermine the ability of the new system to restructure firms that will have significant going concern value when their promoters stay involved. Furthermore, because it is easier under the Code for any creditor to force a firm into insolvency much sooner than before, it is also possible that the underlying problem of fraudulent and unscrupulous promoters will lessen over time. The recent steps taken by the IBBI are in the right direction, and it seems sensible to wait and see if they are sufficient as the new system matures.

(This post is co-authored with Adam Feibelman. It first appeared on Ajay Shah's blog, 17 November, 2017)

Monday, November 13, 2017

Regulating consumer finance: Do disclosures matter? The case of life insurance

In any market, including the market for financial products, we expect that consumers read and understand disclosures about products, weigh the costs and benefits, and make an informed choice regarding purchase. Financial firms, however, respond to disclosure requirements by showing customers large quantities of paper full of jargon. Disclosures become obfuscated, and product features, terms and conditions, hard to decipher. There is also an information overload. Even highly financially literate customers find it difficult to read and understand what is on offer. They make decisions that they often come to regret as product outcomes unfold. Firms claim that customers had signed off on having understood all terms and conditions, leaving little recourse to customers. 

In this context, a 2015 Ministry of Finance Committee set up to, 'Recommend Measures for Curbing Mis-selling and Rationalising Distribution Incentives in Financial Products'(also known as the Bose Committee) made several recommendations on improving product disclosures. Many regulators in India have continuously made changes to their disclosure regulations in order to improve consumer protection outcomes.

One would find it hard to argue that disclosures shouldn't be better designed. The devil is, however, in the details. How do we design effective disclosures? Even if disclosures are made simple, would consumers pay attention to them? Would they change behaviour because of the disclosures? How have customers reacted to changes in disclosure regulations? What have we learned about what kinds of disclosures would have the desired effect? What more do we need to understand? How does this shape our thinking about financial regulation? 

In a recent paper, Regulating consumer finance: Do disclosures matter? The case of life insurance, we use a sample-survey based experiment to understand the effect of simplified disclosures on an endowment insurance product.

We chose an endowment insurance product as this is a composite product that bundles insurance and investment, that often has a detrimental impact on potential returns which customers may not be aware of. Product brochures also showcase returns not on the amount invested, but on sum assured, making it difficult for customers to decode the real costs and benefits of the policy. This product has some of the most opaque disclosures as compared to other financial products in the market such as mutual funds, pension funds and small saving products such as the Public Provident Fund, or the National Savings Certificates.
Experimental design and results

We conducted household surveys in the cities of Mumbai and Delhi. The survey captured demographic and socio-economic details of the respondent such as age, gender, marital status, education, occupation, and household income. It also asked questions on attitudes to risk, retirement, basic questions on financial literacy, and prior purchase of insurance. 

We then offered customers a product brochure which consists of an investment of INR 50,000 a year for 5 years, with a tax break on income, and tax-free returns, INR 500,000 life insurance cover for 15 years, and regular money back across the life of the policy. 

We randomised survey respondents into one of four product advertisements (Treatments): 1) a baseline product with no additional disclosure, 2) disclosure of the actual rate of return on the product, 3) disclosure of the rate of return and a benchmark return of a similar product, namely the Public Provident Fund (PPF), and 4) the rate of return, benchmark return and product features of a more cost-effective competing term insurance product. 

We then asked respondents: did they think that the product was a "good" product? Would they consider purchasing this product? If not, why not?
We chose these disclosures because when a customer buys a financial product, she must look at several attributes. The most easily understood attribute is returns. But bench-marking those returns to an industry standard, comparing to an alternate investment and mapping real return are some of the key determinants to rational consumer choice. Investors, should ideally, look for and use all these metrics of information. Our treatments, therefore, progressively added information on these attributes to map the impact on potential buyers. We expected approval rates for the products to drop drastically for those in Treatment 4 over Treatment 1.

Our results can be summarised as follows:
  1. The group which saw the disclosure related to the rate of return on the insurance product (Treatment 2), was 2.6 percentage points less likely to think that the product on offer was a 'good' product relative to the group that saw the baseline product with no additional disclosure.
  2. Treatments which show additional data such as a comparison rate of return, or the price of a term insurance plan had no effect relative to Treatment 1, which had no additional disclosures.
  3. Those with a higher score of financial literacy, and greater concerns about retirement react to the disclosure only in Treatment 2. Surprisingly, non-purchase of insurance in the past matters for effectiveness on product perception.
  4. None of the treatments had an impact on the intention to purchase.
When respondents were given more than one piece of information, such as the rate of return plus benchmark, or the rate of return plus the benchmark plus the price of a pure risk product, they seem to have tuned out. Disclosures appear to work only when it is about a product feature customers know and understand. The concept of returns is something most people understand, and hence they are able to digest it quickly. Basic financial numeracy and retirement preparedness help towards recognising the returns disclosure but not much else.


The results of this experiment were contrary to our expectations that clear disclosures will change investor perception. The only disclosure that was read and understood by customers was that of returns. This suggests that for disclosures to have any effect, customers need to have a minimal understanding of the product features that are being disclosed. 

These results make us pause about the role of disclosures in consumer protection regulations in finance. It is tempting to require financial firms to keep improving their disclosures. But if disclosure regulations are not based on sound research of what really works, then we are imposing an unnecessary burden on financial firms, and ultimately consumers. 

What we need is a continuous and systematic process of design and evaluation of disclosures. This requires thinking on what makes a good disclosure, and whether the disclosure is having the desired effect. In parallel, we must think about other measures that can improve customer's ability to understand the various disclosures. For example, it would be insightful to evaluate if after some basic financial literacy training on what makes a good financial product, buyers are better able to understand disclosures, and make more informed choices. 

(This post is co-authored with Monika Halan. It first appeared on Ajay Shah's blog, 12 November, 2017)

Why Rajasthan government’s decision to return to old pension scheme is a fiscal disaster

 by Rajiv Mehrishi and Renuka Sane We wrote in the Indian Express about the Rajasthan government decision to revert back to the Old Pension...