The Need for a Special Situation Fund (SSF)
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Context
Two crucial reforms earlier this year
- Indian financial markets witnessed two crucial reforms earlier this year.
- Both these reforms are aimed at solving India’s bad debt problem.
SEBI
- SEBI came out with a dedicated regulatory framework for special situation funds (SSFs).
RBI
- The RBI approved the new dual-structure bad bank, NARCL-IDRCL.
While the bad bank is an upgraded version of the existing asset restructuring companies (ARCs) model, the SSF is a relatively novel concept.
How bad debts hurt economic growth?
- India suffers from a chronic bad debt problem.
- Higher bad debt requires higher provisioning, locking up more capital in the banking system.
- This reduces the credit supply and hurts economic growth.
A way to solve this problem
- To overcome this problem, banks and financial institutions were initially allowed to sell their stressed loans only to ARCs.
- Now they can sell to SSFs too.
- Transfer of stressed loans to ARCs and SSFs would release capital locked-up in the banking system and help improve credit supply.
Special Situation Funds (SSFs): A major reform in the right direction
- SEBI has introduced SSFs as a distinct sub-category of Category I Alternative Investment Funds (AIFs).
- AIFs manage privately pooled funds raised from sophisticated investors with deep pockets.
- While AIFs have traditionally played a prominent role in equity markets, their participation in distressed debt markets has been limited.
- Regulations did not permit AIFs to participate in the secondary market for corporate loans extended by banks and NBFCs.
- The new regulations now create a special sub-category of AIFs, namely SSFs, which are allowed to participate in the secondary market for loans extended to companies that have defaulted on their debt obligations.
- This is a major reform in the right direction.
Why SSFs must be allowed to participate in the secondary market for corporate debt?
Benefit from a lesser haircut
- A haircut is the lower-than-market-value placed on an asset when it is being used as collateral for a loan.
- The size of the haircut is largely based on the risk of the underlying asset.
- Riskier assets receive larger haircuts.
- A haircut also refers to the sliver or haircut-like spreads market makers can create or have access to.
- Default is a lagging indicator of financial stress.
- If lenders and bond investors could offload potentially stressed assets to SSFs before defaulting in the secondary market, they would benefit from a lesser haircut.
Adequate time for debt aggregation
- SSFs would also get adequate time for debt aggregation before default, reducing the collective action problems that may arise after default during insolvency or restructuring.
Improve the liquidity
- Allowing SSFs to purchase investment-grade loans would also improve the liquidity in the secondary market for corporate loans.
- Traditionally, banks originated loans and held them till maturity.
- Over time, lending moved from involving a single lender to multiple lenders via syndicated lending.
- As volumes in the primary syndication market increased, demand for secondary trading also developed to allow liquidity, risk and portfolio management.
Sync with international practice
- Secondary trading of loans is now institutionalised in international financial markets.
- These markets are liquid precisely because they are open to a wide variety of non-bank participants including insurance companies, pension funds, hedge funds and private equity funds.
- Allowing SSFs entry into the secondary market would therefore be in sync with international practice.
- The RBI task force on secondary markets for corporate loans, chaired by T N Manoharan, made this suggestion in 2019.
Unlikely to jeopardize financial stability
- SFs cannot borrow funds or engage in any leverage except for temporary funding requirements.
- Consequently, risks associated with liquidity, credit or maturity transformation and asset-liability mismatches are unlikely to arise.
- Given their structure, SSFs are likely to acquire sufficient debt in a distressed company to acquire control or to influence its subsequent insolvency or restructuring process to maximise its value through business turnaround or sale.
Way Forward
- Overall, the introduction of SSFs promises to usher in a modern era of distressed debt investing in India.
- To realise their true potential, SSFs must be allowed full participation across the entire spectrum of the secondary market for corporate debt and not just be confined to the post-default stage.
Practice Question for Mains
- Discuss how the introduction of Special Situation Funds (SSFs) in India promises to usher in a modern era of distressed debt investing. (250 Words,15 Marks)
Referred Sources
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