It has often been said that it takes a crisis to bring about reforms in India. There may be some truth to that. The Indian banking sector has been edging closer to crisis in the last year. And this may have helped spark potentially far-reaching changes in the way debt and default are to be treated.

A new circular from the Reserve Bank of India outlines a proposal whereby banks will be empowered to take over companies that default on loans. The Securities and Exchange Board of India has already amended its regulations to make this possible.

The devil is in the details. But those are highly technical. So let’s see what we understand conceptually.

Ways to recover cash

Businesses are financed by equity (money put in by the owners), debt (loans which must be repaid) and profits (if any) ploughed back into the business by owners. Equity is risk capital. The party with a controlling equity stake runs the business. Equity holders receive either profits or losses while the creditors are paid agreed-upon rates of interest.

When a business defaults on a loan, the lender (or lenders) has several options to try and recover the cash, or some of it.

One possibility: Restructure the terms of the loan by giving the borrower more time or reducing the rate of interest, etc. Banks often take this route. A consortium of bank-lenders meets the borrower to restructure and renegotiate a sticky loan.

Another possibility: Foreclose on the assets of the business and sell those assets. Often businesses, which are stressed by large outstanding debts, indulge in voluntary “deleveraging” and sell their own assets to reduce the debt burden.

Another possibility: Convert outstanding debt into an equity stake. Here, the lender becomes an owner, or part-owner. If the erstwhile lender becomes the majority stakeholder, controlling over 50% of equity, it can force changes in management. Or it can sell off its stake.

In management jargon, “strategic” is often a codeword for a controlling equity stake, or a stake (minimally 26%) that allows for a seat on the company’s board. A lender might end up with a “strategic” stake, if it converts an outstanding loan into a sufficiently large equity stake.

Converting debt to equity is not new. Many instruments have this clause, without the borrower being under any stress. The entire class of “convertible debentures” for example, involves conversions of debt into equity. This sort of conversion is also popular in cross-currency instruments, often called Foreign Currency Convertible Bonds.

In such cases, many terms and conditions are attached. For example, the conversion will take place at an agreed-upon share price, at an agreed time period, if the rupee-USD exchange rate is placed within a certain band, etc.

The government of India has opted to do this sort of conversion many times with loss-making public sector units. For example, debt has been converted into equity in Air India and Steel Authority of India Ltd.

Threat to takeover

Banks can now write in such a clause for the conversion of debt into equity when restructuring a loan. One issue is that SEBI’s Takeover code, the Substantial Acquisition of Shares and Takeover regulations, says that an entity acquiring 25% equity stake in a publicly listed company must make an open offer for another 26%. That open offer clause has been waived by SEBI for banks converting debt into equity in strategic restructurings.

What does this mean in practice? Well, it is unlikely that banks will attempt to actually run businesses. Bankers are not in the business of iron ore or coal mining, or flying planes, or making wind turbines, steel, cement, or constructing and operating roads, ports and power stations.

But the banks can, in theory, take over defaulters and then sell their stakes to somebody who may be interested in running the business. Or, they could replace the current management with nominees of their choice. This threat might induce defaulters to pay.

A conversion provision will henceforth become part and parcel of restructuring negotiations. Over the past three years, an enormous quantum of loans – over Rs 4.5 trillion or Rs 4,50,000 crore – have been restructured. In practice, about 15% of restructurings turn into full-blown bad assets, meaning the borrower cannot pay even under the relaxed restructured conditions. The RBI has just introduced tough provisioning for restructured loans (“Provisioning” means money banks keep aside to cover possible defaults).

At the same time, such a conversion will kick in only if 75% of creditors by value, and 60% of creditors by number, agree to convert. So the new norms on strategic debt restructuring seem to be more of a theoretical possibility than a realistic threat as they stand.

Nevertheless, given that the Indian banking sector is struggling and close to crisis, it might seek desperate solutions.

Saving public banks

Stressed loans of banks are already above 10% of total loans. Impaired assets (bad loans, restructured loans, outstanding bonds to loss-making state-owned power distribution companies) could rise above 13% of all loans by March 2016, according to the rating agency ICRA. To put that in perspective, bank equity consists of 8% or so of total loans. Potentially, the entire equity stake in India’s banks plus accumulated profits could be wiped out if all these loans go sour.

Over 70% of all loans are advanced by public-sector banks where the government of India holds the majority stake. The PSU banks are far more exposed to bad loans. Private banks are better capitalised (they have much higher equity-to-loan ratios) and they have less bad loans on their books.

Even if, by some miracle, all those impaired assets don’t go belly up, at the minimum, the government must subscribe an extra $40 billion to the banks it controls by 2018. This is in order to meet global prudential norms for banks.

The RBI has already pushed back the schedule for Basel II compliance because a) the government of India doesn’t have the money b) the government is reluctant to sell equity and bring its stake down below 50% in some banks in order to raise the money.

At the same time, the demand for credit has eased down to 20-year lows, which means that new business isn’t coming in for banks. Outstanding commercial credit rose 9.5% in 2014-15, a drop from an already low 13.7% growth in 2013-14 and 15% growth in 2012-13. Low credit growth makes it impossible for the banking sector to get big enough, fast enough, to make the bad loan problem insignificant.

The new norms might not be directly applicable. But this is symptomatic of a new tough attitude. If that translates into less political interference in public sector banks, they might be allowed to operate on commercial terms. And that would be good for the sector.