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The FRDI Bill and the Bail-in Clause

The recent debate regarding the FDRI bill, particularly about the bail-in clause, has been boiling as more and more depositors are getting worried about the future of their savings. Speculations have been raised, with many newspapers articles and television news media programs touting this bill as a start of a “financially instable situation” created by the Finance Ministry. So, to clear these emerging doubts, let us look at what the FRDI Bill is and what are the implications of the bail-in clause within it.

The FRDI Bill and the Bail-in Clause

The Financial Resolution and Deposit Insurance (FRDI) Bill, introduced in the parliament in August 2017, seeks to regulate India’s financial institutions and also lay the foundation to wind down, revive, or resolve an ailing financial services company.

The principal objective of the Bill is to provide a framework for the resolution of financial institutions, covering the entire financial sector. The bill seeks to establish a Resolution Corporation (RC), whose primary objective will be to regulate and oversee the operations and activities of the existing financial service providers. The members of the RC will comprise of members from the RBI, SEBI, IRDA, PFRDA, the Central Government and also a few independent members.

The Resolution Corporation will lay down some criteria to classify all financial service providers. They will then fall into five categories called categories of “risk to viability” viz. low, moderate, material, imminent, and critical. This will be based on their (i) capital adequacy, (ii) asset quality, (iii) management capabilities, (iv) earnings, and so on.

If a situation arises, wherein, the service provider falls into the material or imminent category, it will have to submit a restoration plan to the RC. And once under the purview of the RC, its performance will be subject to periodic review and inspections by the RC. The RC will then assess whether it breaches the critical risk to viability criteria.

If the financial service provider breaches the critical mark, the resolution process can involve the following:

  1. transfer or acquisition of assets
  2. merger or amalgamation with another healthy financial firm
  3. liquidation
  4. utilization of new resolution instruments like bail-in

The Bail-in reform implies that, once triggered, the bank has the right to recapitalize itself by using the money from the depositors account, thereby holding them equally liable in the process.

The bill also provides for the designation of certain financial service providers as “systemically important financial institutions” (SIFIs) by the central government, the failure of which may disrupt the entire financial system, given the size, complexity, and interconnectedness with other financial entities. The RC will have additional powers in respect of such SIFIs, with risk assessment, restoration, and resolution being subject to more stringent conditions.

Why is it being Implemented?

The official argument for the reason behind the implementation of the FRDI bill is that there is no specific, standalone law to deal with the failures of financial institutions in the country. But if the history of banking is brought to the purview, it is noticed that, after nationalization of banks in the 1960’s, not a single PSB has failed in the country. All the bank failures in the post-liberalisation period have been of private sector banks, which were compulsorily amalgamated with PSBs to protect the interest of the depositors.

Several small urban and rural cooperative banks have also faced such situations, with the RBI cancelling their licenses and the Deposit Insurance and Credit Guarantee Corporation (DICGC) settling the claims of their depositors over time. But the bigger banks as well as the broader financial system in India have been stable over the decades, remaining largely unscathed even during and after the global financial crisis of 2007–08. In fact, bank failures have in fact become rarer and rarer over time in the recent past.

This proves to show that the changes in the resolution regime are clearly not being driven by the domestic financial conditions. Then what is the reason?

Global Financial Resolution Reforms

What has indeed driven this process of regulatory overhaul, about the financial resolution regime in India, is the pressure emanating from the Group of 20 (G20) and the Financial Stability Board (FSB). They have been setting the financial regulatory reform agenda since the global financial crisis of 2008.

The FSB proposed a resolution called “Key Attributes of Effective Resolution Regimes for Financial Institutions” which was endorsed by the G20 heads of states at the Cannes summit (November 2011). The resolution provided the countries with a blueprint of the actions that needed to be taken as far as the resolution of financial institutions was concerned. The FSB expected that the creation of powerful resolution authorities across jurisdictions (Countries and States) would address the moral hazard problem involving the giant global banks and financial institutions. Further, in the resolution, it provided options to either stabilise an unviable financial firm- through transfer or sale of assets to a third party and/or taking recourse to bail-in.

The FSB provided information on the bank resolution reforms to be carried out in the FSB jurisdictions in terms of the following resolution tools:

  1. powers to transfer or sell assets and liabilities;
  2. powers to establish a temporary bridge institution;
  3. powers to write down and convert liabilities (bail-in);
  4. power to impose temporary stay on early termination rights;
  5. resolution powers in relation to holding companies;
  6. recovery and resolution planning for systemic firms
  7. and powers to require changes to firms’ structure and operations to improve resolvability.

While trying to set up an omnibus resolution authority, with powers to resolve financial institutions across the spectrum, the FRDI Bill has basically followed the template set in the FSB’s “key attributes” in toto. It has accommodated within its bill all the reforms suggested by the FSB.

Countries That Have Implemented the FSB Reform

The latest FSB report (July 2017) shows that on the one hand, countries like France, Germany, Italy, Netherlands, Spain, Switzerland, Hong Kong, United Kingdom (UK), and the United States (US) have already implemented all the resolution tools; Japan has implemented all but the bail-in reform; and Canada all but the powers to require changes to the firm’s structure. On the other hand, countries like Argentina, Australia, Brazil, China, Indonesia, South Korea, Mexico, Saudi Arabia, Singapore, South Africa, and Turkey have implemented the reforms only partially, with none of them implementing the bail-in provision.

In this context, it seems that, while the advanced economies are clearly pushing this resolution reform agenda, the emerging or developing economies are more cautious about them, particularly the provisions of bail-in. The other provisions have been implemented in certain jurisdictions, but not in others.

India had not implemented any of the provisions as of May 2017. Now, the FRDI Bill 2017 seeks to implement all the resolution tools suggested by the FSB key attributes at one go, and that too in the form of an omnibus legislation.

The Indian Context

While the system in North America and European countries are dominated by large private banks and financial institutions, it is the public sector that dominates the financial sector in India, China, and many other developing economies.

The crisis that engulfed the financial sector in 2008 was an outcome of the inherent problems of a financial system that was privately owned, market-based and deregulated. The problems afflicting the financial systems of economies like China or India, such as the bad loans accumulation in PSBs, are of a qualitatively different nature. A one-size-fits-all regulatory approach in resolving these distinct problems is bound to fail and backfire.

Moreover, the Indian case is also unlike China’s, given the vast difference in the size of their state-owned financial institutions. The “big four” state-owned banks in China, namely the Industrial and Commercial Bank of China, China Construction Bank Corporation, Agricultural Bank of China and the Bank of China, with total assets worth $3.4 trillion, $3 trillion, $2.8 trillion, and $2.6 trillion respectively, have emerged as the four largest banks in the world today, ahead of Japan’s Mitsubishi UFJ Financial Group ($2.58 trillion), US’s JPMorgan Chase ($2.49 trillion) and UK’s HSBC ($2.37 trillion).

In contrast, India’s largest bank, the state-owned State Bank of India (SBI) ranks 55 among the top 100 global banks with assets worth $493 billion. No other Indian bank appears in the top 100 list. None of the Indian banks appear in the list of 30 Global Systemically Important Banks (G-SIBs), identified by the FSB, which need to maintain higher capital buffers and meet other stringent regulatory benchmarks compared to other banks. Therefore, there is no case for a wholesale emulation of the financial resolution methods and tools of the advanced economy to financial systems in India.

Deposit Insurance Coverage Limit

Deposit Insurance cover refers to the amount that is deposited in the bank (in savings accounts, FDs, current accounts etc.) that is insured by the DICGC. This amount is to be paid back to the depositors if the bank undergoes a bad financial crisis.

The most serious issue pertaining to the proposed FRDI bill is of the omission of the maximum deposit insurance amount. The FRDI bill seeks to repeal the reformed DICGC Act (1993) and provides the provision of a bail-in, in which the bank can utilise depositors’ money to recapitalise itself. It mentions no limit for the Deposit Coverage.

Since there is no mention of it, the maximum deposit insurance amount has been kept at the same level of ₹. 1 Lakh which was fixed almost 25 years ago. A simple adjustment for retail inflation since 1993 (when the ₹1 lakh deposit insurance limit was set) for the past 24 years would imply that the limit today should not be less than ₹5 lakhs.

The official justification for maintaining the deposit insurance coverage limit at the present low level is that 67% of term deposits currently being held in the commercial banks are below ₹1 lakh and only 1.3% of the term deposits are over ₹15 lakhs; and hence small depositors are adequately covered under the present coverage limit. But, this argument is faulty in its reasoning. The current minimum wage rate of ₹300 per day for unskilled employees, as notified by the central labour ministry, means that the annual income of a family of agricultural workers, who are among the poorest sections of society, would inherently exceed ₹1 lakh.

Moreover, bank deposits have historically been the main vehicle in which financial savings of Indian households are parked. So, the issue is not of the small versus large depositors but of the security of bank deposits. The average householder prefers to deposit his/her savings in bank accounts as opposed to other financial instruments. This makes it even more important to ensure the security of those deposits. From the point of view of systemic stability, the trust and confidence of the depositors in the banking system is vital, especially in the Indian context.

Implications for PSBs

The history of financial resolution in India in the period since bank nationalisation shows that government ownership of banks has made a big difference. This is not only in preventing frequent bank failures but also protecting the depositors from failing private banks through amalgamation/merger with PSBs. While it is at times difficult for the PSBs to match the profitability or service quality of private and foreign banks, accountability to the government and the public keeps the PSBs away from risky and speculative financial activities. Therefore, the confidence of the depositors does not generally erode in the PSBs even with a deterioration in bank financials.

Also, by bringing the public sector financial institutions and those in the private sector under a common resolution regime is an impracticable aspect of the FDRI bill. The PSBs function as the cornerstone of systemic stability as far as the Indian financial system is concerned, a fact that has been noted by the RBI. If the governmental guarantee for protecting PSBs and other public financial institutions from failures is diluted and the powers to resolve them divested from the government, it will adversely affect the trust and confidence of the depositors in the PSBs and weaken the entire financial system.

The controversial bail-in provision also needs to be seen in this context. The RBI working group on the resolution regime, while not rejecting the bail-in mechanism per se, had recommended that deposit liabilities, inter-bank liabilities, and short-term debt be entirely excluded from its purview, because these liabilities “if subjected to bail-in can induce financial instability.”

However, the FRDI Bill ignores that recommendation and only excludes:

“any liability owed by a specified service provider to the depositors to the extent such deposits are covered by deposit insurance” [Section 52(7)]”

This implies that deposit amounts over and above the deposit insurance cover limit are included under the bail-in mechanism. Similarly, short-term debt over seven days maturity and unspecified categories of “client assets” have also been kept within the bail-in purview. If such provisions are enacted, there can be a serious flight of depositors and creditors away from the PSBs and other public sector financial institutions.

None of the emerging or developing economies, which have undertaken resolution reforms, have implemented these risky provisions so far. Even the RBI working group considers such provisions to be hazardous. If the government genuinely intends to create a robust financial resolution regime, which will enhance rather than erode the trust of the public in the financial system, these harmful provisions of the FRDI Bill need to be removed altogether as a prerequisite.

Conclusion

There are both pros and cons of creating a single authority like the RC to deal with resolution for the entire financial sector, as envisaged in the omnibus FRDI Bill. While it can create common regulatory standards across all segments of the financial sector, bring more financial institutions within the purview of deposit insurance, and make the process of resolution speedier and more efficient, there are serious possibilities of conflicts arising between the regulators and the RC over the classification of ‘risk to viability’ of a financial firm as well as over its restoration or resolution plans.

Another serious concern regarding the creation of an omnibus RC relates to the problems arising from maintaining multiple reform criteria. Given the diversification of financial conglomerates into sectors like banking, insurance as well as the securities market, a diversity of regulators would perhaps better serve to protect the regulatory processes from vested interests. All these concerns need to be addressed and the costs and benefits carefully weighed before effecting an overhaul in the resolution regime in India through the creation of an all-powerful RC.

The proposed powers of the RC to deny emoluments and bonuses of employees of a financial service provider under various stages of resolution, to change their service conditions, and even terminate them without recourse to other avenues of justice, need serious reconsideration since they militate against the hard-won rights of the employees.

Moreover, the latest Financial Stability Report (December 2017) has reported a 3.3% drop in the year-on-year deposit growth for all scheduled commercial banks, cutting across all bank groups, between March and September 2017. This is an unwelcome time for the government to press for the passage of a bill whose provisions can erode the trust and confidence of the depositors in the PSBs and other public sector financial institutions.

While the proposed reforms in the financial resolution regimes have been pushed by the advanced economies through the FSB, such a reform agenda is not grounded in the Indian realities. While in the advanced economies the financial institutions have had their fair share in experiences of bank failures and taxpayer funded bailouts after the global financial meltdown of 2008, in India the dominance of PSBs had ensured the insulation of the financial system from the vicissitudes of the crisis. Ironically, the FRDI Bill 2017 seeks to weaken the same PSBs and public sector financial institutions by diluting their sovereign guarantees and introducing resolution provisions like bail-in. To build a more effective financial resolution regime in India, not only should these potentially destabilising provisions of the FRDI Bill be reconsidered, but the deposit insurance cover limit also needs to be enhanced substantially. The desirability of an omnibus Resolution Corporation requires further debate, in the context of relevant experiences of other emerging and developing economies.