Efficient priority rules and the Indian IBC

Abstract

India passed a comprehensive and new Insolvency and Bankruptcy Code (IBC) on May 28, 2016. Prior to this, institutional debt defaults were handled through a number of different laws and regulations, like SICA, 1985, Debt Recovery Act, 1993, SARFAESI, 2002 and Company Law, 2013. In addition, for companies above a certain size, the High Courts had to be involved, especially in winding up decisions. The IBC, being a uniform code, was meant to reallocate assets more efficiently and quickly. In this paper we develop a model that gives rise to credit rationing as a result of moral hazard and investigate the efficiency of three different possible priority rules: (a) when financial creditors have priority over operational creditors (b) when operational creditors have priority over financial creditors and (c) when both have equal priority. We argue that the extent of credit rationing is invariant under all three priority rules. We then show why a cost of business indicator that looks only at the price of inputs is flawed in determining efficiency.

Keywords: Bankruptcy Code, Credit rationing, Debt Recovery

JEL Classification: K22, G33