Slow-Motion Bankruptcy

India's Economic Times has a good article on how the shock of the Andhra Pradesh microcredit law is bouncing around inside the microfinance and banking industries.Broadly, there is no news here. The Andhra Pradesh government's unremitting clamp on the artery of loan repayments means that the limb almost certainly has to be amputated. The simple math of exposure and leverage put some microfinance institutions (MFIs) in grave danger the instant the law was announced. It has just been a question of who will take the loss, and when it will be formally recognized. Broadly, two clocks are at work:

• The repayment schedules on loans from banks to MFIs. An MFI can have nothing coming in but maintain appearances until a big loan payment to a bank comes due.
• Accounting rules. Both MFIs and the banks that lent to them are subject to accounting rules about when to provision for and write-off loans in default. Even when nothing in the real world has changed, accounting actions taken under these rules can have domino effects at the moments they happen. Conceivably, for example, a bank's capital base, its loss-absorbing equity cushion, might shrink below the legal minimum, forcing it to raise more capital from investors. More likely, formally recognizing losses on loans to MFIs will lead banks to foreclose. Some months ago the Reserve Bank of India loosened accounting rules to forestall foreclosures.

As for who absorbs the losses, standard bankruptcy principles apply (though I don't know how they play out in India). Equity investors should take first losses. If they are wiped out, then the banks who lent to the MFIs will have to absorb the rest of the losses (unless the government swoops in with aid, which seems unlikely). The question then for each MFI will be whether the banks can get more value out of it by liquidating it or by keeping it as a going concern, in which case banks would become major shareholders. The bar is low for keeping MFIs operating since they are worth so little in liquidation. On the other hand, it seems clear that Andhra Pradesh has more microcreditors than can be viable long term, which might be to say, more than zero. The MFIs that survive will be the ones that already have substantial operations outside of the state.