Equity market reaction to regulatory reforms: a case study of Indian banks


Purpose Non-performing assets (NPAs) have been a cause of concern for the banking sector across the world and have invited a lot research interest, especially for emerging economies. In India, the NPAs grew many folds and reached alarming levels in 2013. The available mechanisms, such as Corporate Debt Restructuring Scheme, were not adequate to address this issue. The Central Reserve Bank of India with the Government of India introduced various guidelines, schemes and... (see full summary)

Equity market reaction to
regulatory reforms: a case study
of Indian banks
Madhvi Sethi
Symbiosis Institute of Business Management Bangalore, Symbiosis International
(Deemed University), Pune, India, and
Dipali Krishnakumar
Department of Finance, National Institute of Bank Management, Pune, India
Purpose Non-performing assets (NPAs)have been a cause of concern for the banking sector across the
world and have invited a lot research interest,especially for emerging economies. In India, the NPAs grew
many folds and reached alarming levels in 2013. The available mechanisms, such as Corporate Debt
Restructuring Scheme, were not adequateto address this issue. The Central Reserve Bank of India with the
Government of India introducedvarious guidelines, schemes and regulations like frameworkfor revitalizing
distressed assets to tackle NPAs during the period 2013-2017.Taking the case of India, the purpose of this
paper is to examine policy initiatives and analyse the impact of regulatory shocks on the equity market
returns andthe systematic risk of individual banking stocksusing an extended version of the market model.
Design/methodology/approach In this study, the authors design the experiment to explore the
reaction of bankingstocks to the various regulatory measures and also measure the change in systematic risk
for these stocks as a result of theregulatory changes. Following the approach suggested by Soraokina and
Thornton(2015), the authors use the extended market model to test the reaction of banking companystocks to
the regulatorymeasures.
Findings The study nds that banking stocks did not earn signicant abnormal returns on the announcement
of these measures. However, the systematic risk of the banking index reduced signicantly on the introduction of
regulatory measures, and this risk reduction has been primarily in the stocks of private sector banks.
Research limitations/implications This paper provides insights on the equity marketsshort-term
reaction to the reforminitiatives introduced by the government. The scope of thepaper is with respect to one
emerging economy, India, which underwent a series of regulatory reforms to tackle the banking NPA
Originality/value The paper lls an important research gap where the impact of schemes and
regulations is captured for an emerging economy like India. It tries to bring forth the importance of these
reforms and howan investor perceives the same. This paper tests forchanges in systematic risk as measured
by market beta as well as measures cumulative abnormal returns associated with important events in the
process of regulatoryreforms happening in India from 2013 to 2017.
Keywords Banks, Systematic risk, Event studies, Banking policies,
Financial institutions and regulation, Financial market
Paper type Research paper
Introduction and motivation
Creditor rights have been linked to nancial development and evidence has suggested that
lowering the cost of credit may foster nancial development(Porta et al., 1997;Levine, 1998;
JEL classication G21, E58, G14, G28, G18, G32
Case study of
Indian banks
Received3 September 2019
Revised20 December 2019
Accepted25 February 2020
Journalof Financial Regulation
Vol.28 No. 3, 2020
pp. 431-464
© Emerald Publishing Limited
DOI 10.1108/JFRC-09-2019-0114
The current issue and full text archive of this journal is available on Emerald Insight at:
Djankov et al.,2007;Haselmann et al., 2009). One way of lowering the costs is through
strengthening creditor rights which would lead to decline in the use of credit by rms.
Vig (2013) examined the effect of nancial reform which strengthened the creditor rights
and found that it led to reduction in secured debt,total debt, debt maturity and asset growth.
The study emphasized that strengthening creditor rights might lead to rms altering their
debt structures. Vig (2013) used the Indian economysetting for this experiment, specically
the passing of Securitization and Reconstruction of Financial Assets and Enforcement of
Security Interests Act, 2002 (SARFAESI).In an emerging economy like India, policymakers
have been insisting on the development of the restructuring mechanism, so that the lenders
(mostly banks) could improve the recoveryand hence the health of their balance sheets. For
understanding the extent of reformsover a period of time and how these are accepted, India
has been chosen for this study. India is a good subjectfor this study because of the urry of
reforms introduced for debt restructuring. Also, in India, banks have been a popular source
of nancing corporate activities and the market reaction to these reforms can be examined
by studying the stock market reaction of bank stocks. Sengupta et al. (2016) provide a
detailed commentary on the evolution of insolvency framework for Indian non-nancial
rms. The Companies Act, 1956 was the rst law to address corporateinsolvency for Indian
rms. Although the Companies Act, 1956 did not deal directly with insolvency and
bankruptcy code (IBC), it covered aspects of rms inability to pay debt and winding up
proceedings. The winding up proceedings were adjudicated by the High Court. Sengupta
et al. (2016) reported that the number of cases registered and resolved was abysmal
compared with the number of registeredcompanies in India indicating a very low usage of
the Companies Act for dealing with insolvency.
Post-independence, the Government of India took various initiatives to provide impetus
to the growth of industrial sector. A large number of companies failed, majority of these
were highly leveraged and had borrowedheavily from Developmental Financial Institutions
set up under Government initiative.In the 1980s, there was a widespread crisis of industrial
sickness which was adversely impacting the nances of banks and nancial institutions.
The Sick Industrial Companies Act (SICA) was passed in 1985 with the objective of
restructuring sick companies. A Board of Industrial and Financial Reconstruction (BIFR)
was set up as the adjudicating authority. This act covered only industrial companies and
required the board of the company to declare sickness. The mechanism under the act
provided a stay from other proceedings and claims thus providing protection to the
company and also permitted the debtor management to continue to manage the rm.
Proceedings under BIFR took an inordinate time to resolve. Even if a case was adjudicated
for winding up by the BIFR, many cases were re-examined by the High Court causing
further delay. The SICA seemed to provide more protection to the borrower rather resolve
debt recovery issuesfor the creditors.
With the intention of strengthening creditor rights, the Recovery of Debts due to Banks
and Financial Institutions Act, 1993 (RDDBFI) was enacted upon the recommendations of
the Narasimhan Committee I. Debt recovery tribunals (DRTs) and debt recovery appellate
tribunals were set up toprovide a mechanism for expeditious recovery of debt by banksand
specied nancial institutions. This act created a special classof creditors that had superior
rights over other claimants,such as operational creditors and workmen for recoveryof dues.
Recovery under RDDBFI too has not been very successful and suffered from several
weaknesses includinglow recovery rates.
The Reserve Bank of India (RBI)set up the Corporate Debt Restructuring (CDR) Scheme
in 2001 to provide debtors and creditors a mechanism for out of court settlement of dues
where outstanding dues were more than INR100m. The CDR scheme comprised of a three-
tier approach to scrutinize the initial proposal. It had a standing forum to formulate
guidelines at the top, an empowered group to approve the scheme and the CDR cell to
prepare the restructuring plan. Under the scheme, the lender could forgo some of the loan
amount and extend the repaymentperiod. RBI permitted banks to make lower provisions for
loans under CDR. The mechanism was slow and was believed to be not very effective in
dealing with the non-performingasset (NPA) problem.
The growing NPA problem led to the setting up of one more committee, i.e. the
Narasimhan Committee II and Andhyarujina Committee in 1998. These committee
recommendations led to the enactment of the SARFAESI, 2002. This Act provided
banks and nancial institutions the power to take possession of debtors collateral
assets. Proceedings under SARFAESI took precedence over BIFR proceedings if agreed
by 60 per cent of creditors in value. The SARFAESI Act has been more successful in
recovery of NPAs; however, it too has certain shortcomings. SARFAESI Act gave more
rights to secured creditors in recovery of dues to the detriment of other creditors. When
creditors took possession of assets, there was no provision for continuing the business
as a going concern, thus leading to a reduction of value of the business during the
recovery process.
Despite several laws and schemes, therewas no single law that would deal with dues of
various creditors. For example, Ravi (2015) has given an example of a judgment wherein
actions against a debtor had been initiated in ve different legal forums, namely, under
DRT, winding up with High Court, under SARFAESI, under arbitration clause, and by an
unsecured creditorin the civil court.
RBI in its discussion paper[1]dated 17th December 2013 mentioned a need to ensure that
the Indian banking system recognize nancialdistress early, take prompt steps to resolve it
and ensure fair recovery for lenders and investors. This step from RBI was in the wake of
rising NPAs in the Indianbanking system due to the economic slowdown.
There has been a steady increase NPAs with commercial banks. Figure 1 depicts the
growth in the value of gross NPAs from 2004-2005 to 2015-2016 for scheduled commercial
banks in India.
Available mechanisms and acts,such as CDR, the SARFAESI, the SICA, were unable to
solve the growing concern of NPAs. Subsequently, several regulatory changes were
introduced commencing withthe discussion paper on early recognition of nancial distress
in December 2013. A summary of the regulatory changes and announcements related to
identication andresolution of NPAs of banks is provided in Table I.
Figure 1.
assets of Indian
from 2004-2005to
Case study of
Indian banks

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