The New LIC “Policy” For IDBI: Insuring Corporate Mortality
A contract of insurance is a contract of utmost good faith technically known as uberrima fides. The doctrine of disclosing all material facts is embodied in this important principle, which applies to all forms of insurance. At the time of taking a policy, policyholders need to ensure that all questions in the proposal form are correctly answered. Any misrepresentation, non-disclosure or fraud in any document leading to the acceptance of the risk would render the insurance contract null and void.
Does this principle apply only to policyholders and not to the insurer? It would seem so. The poor policyholder who pays his regular premiums does so in the belief that s/he is entitled to a share of the surpluses of LIC. It is an implicit contract which presumes that the insurer will utilise its significant cash flows to invest wisely in profitable financial assets to generate returns. It does not include bailing out irretrievably poor businesses which have no buyers in the market. By proposing to buy the Government’s 41% stake in IDBI the LIC is doing just that – and breaking the trust of its policyholders by simply destroying their cumulative accumulated wealth to which they had a future claim in perpetuity.
Though LIC has been the favorite milking cow since times immemorial for the Government of the day, it has been generally used to prop up markets during bear assaults or helping pick up some residual stakes during partially unsuccessful divestment initiatives. In such cases, given market cycles and long holding periods, the case could potentially be made for an eventual profit on what are essentially market investments.
This case is fundamentally different. There are multiple issues of regulation, governance and moral hazards. For very bona fide reasons, IRDA does not allow insurers to take more than 15% stake in any company unless it is for commercially viable reasons. It will be required to make an exception here and for reasons which are nothing to do with commercial viability or financial feasibility. I will come to this topic later but purely from a fiduciary responsibility and governance perspective, both LIC and IRDA would not do justice to their mandated roles as institutions of public faith if they agree to let this transaction materialize. The argument that LIC being a 100% Government institution, and is thus allowed to utilize its resources to bail out failing institutions, without affecting the sovereign guarantee to its policyholders, is largely a self serving argument : the moral hazard it presents is obvious with the government transferring the financial consequences of poor business practices from one entity to another well-run entity under its “control” ( with a completely separate group of stakeholders) without routing it through its own balance sheet. After all, Vijaya Mallaya did pretty much the same thing whilst attempting to keep Kingfisher afloat at the cost of shareholders of United Spirits. The consistently low valuation multiples of Public Sector Undertakings (PSUs) is precisely for reasons of such opaque practices, and future divestment programs of even well-run PSUs will continue to be severely affected if the Government chooses to stay the course on such decisions which essentially impact trust of public stakeholders.
Now, I would like to revisit the core question of the viability of IDBI, and of this transaction. Analysts are of the opinion that NPAs are of the order of 36% of the loan book as against the declared 28% amounting to $ 8 billion. This extra provisioning requirement of about $ 3 billion - to cater to even half of this gap itself - would wipe out the bank’s tier I capital and render it unviable to continue operations. Hence, any funds LIC would pay for this transaction would be worthless. The most critical aspect of this proposed transaction is that the LIC Board has agreed to invest in IDBI without any semblance of a sustainable turnaround plan whatsoever, either in terms of a credible strategy or a management team.
Instead of such ill-advised moves which lack imagination, the IDBI case actually provides a brilliant opportunity to engage in a test case to attempt innovative thinking to tackle what is our most intractable economic problem i.e., public sector banking. This is because IDBI does not fall under the Banking Regulation Act and its problems, and hence solutions, could be both flexible and localized in terms of impact. For example, could the Government consider inviting a team of professional bankers of high repute backed by PE funds to effect a turnaround by handing over management control to these professionals? Innovative financial instruments to incentivize both the management team and the PE funds without diluting the Government’s significant ownership, covenants to have a call option on the upside without voting rights for the existing shareholders, etc. can be structured to ensure all varied interests are aligned towards the common cause of turning around the bank. This is similar to a Management Buy In ( MBI ) structure which forms the basis of many such restructurings in the West.
We have a large market in which the business model of banking is well established by many of the private banks; we have some very astute, credible bankers in our fold ; we have access to funds from large PE investors : all that is needed is innovative and brave thinking in the bureaucracy and the political will “to let go” and do “what is right” to revive IDBI and, if successful, the rest of the PSU banking sector.
PM Modi has shown both political will and fresh thinking in breaking down many entrenched structures in the interest of the common man, much to the alarm of many vested interests. It is time for him to take leadership to drive fundamental change in this case too, the success of which will permanently transform a key bulwark of India’s economy.
If not, then LIC, and other cash-rich state-owned entities, will be doomed to provide such “insurance policies” to more cases of corporate mortality.
