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Imprudent Financial Resolution

The FRDI Bill may introduce instability into the existing financial regime. 

By March 2017, the gross non-performing assets (GNPAs) of scheduled commercial banks (SCBs) taken together stood at around ₹8 trillion, up from ₹2.6 trillion in March 2014. This is despite the generous bad-loan write-offs worth ₹2.4 trillion over the last three financial years. The finance ministry claims that the Insolvency and Bankruptcy Code enacted in May 2016 to expedite the recovery of stressed assets and the proposed Financial Resolution and Deposit Insurance (FRDI) Bill, 2017 to pre-empt any banking or financial institution failures will help resolve the bad loans problem. 

The FRDI Bill proposes to set up a powerful financial resolution authority—a “Resolution Corporation”—to resolve failures of service providers across the financial spectrum. This is distinct from the Insolvency and Bankruptcy Board of India (IBBI), which was set up to recover private corporate sector debt that had long surpassed the tolerable threshold, and was having severe spillover effects on both credit demand and supply at the macroeconomic level. The proposed financial resolution regime attempts to pre-empt any outbreak of a banking or financial crisis by putting in place a new regulatory framework that will ensure the orderly exit of failing financial firms and insulate the larger financial system from possible contagion. There are several reasons, though, as to why the new financial resolution regime proposed in the FRDI Bill may create more problems than it can solve. 

The creation of a Resolution Corporation empowered with new instruments of financial resolution, like “bail-in” and bridge service providers, alongside traditional instruments like acquisition and transfer of assets, is a framework developed by the Financial Stability Board (FSB) under the aegis of the Group of 20 (G20). These resolution reforms complement the Basel III banking regulation reforms involving higher capital adequacy requirements for global and domestic “systemically important banks” and financial institutions. The objective behind these reforms is to address the moral hazard associated with “too-big-to-fail” banks and financial institutions as was and preclude, in the future, state-funded bailouts of failing firms, witnessed during and after the 2007–08 financial crisis. However, that crisis and the reaction to it have little relevance for the Indian financial system, which is dominated by publicly owned banks and financial institutions. In fact, public sector dominance had helped insulate the Indian financial sector from the crisis, a fact noted by the Reserve Bank of India (RBI).

Paradoxically, the FRDI Bill seeks to dilute government guarantees with respect to the debt resolution of public sector banks (PSBs) and public sector financial institutions in India that act as the cornerstone of financial stability. It proposes to divest the government and the RBI of the powers to plan and execute recovery and resolution processes for stressed PSBs and financial institutions, and create a Resolution Corporation. This in turn can invoke a bail-in provision that could convert uninsured bank deposits and other debt liabilities into equity-like instruments in order to recapitalise or liquidate a failing entity. The possibility of a bank run cannot be ruled out. This provision has already caused disquiet among bank depositors and, if enacted, has the potential to induce financial instability. 

Most developing country members of the FSB have so far avoided the creation of a lead authority like the proposed Resolution Corporation, which will subsume all the financial resolution-related powers of the existing regulators like the RBI, Insurance Regulatory and Development Authority (IRDA), Securities and Exchange Board of India (SEBI) and Pension Fund Regulatory and Development Authority (PFRDA). Given the statutory mandate of the RBI with respect to maintaining financial stability, there is potential for regulatory conflicts between the resolution authority and the central bank on the risk assessments of stressed financial firms as well as the methods and instruments of their resolution.

What has added to the uncertainty surrounding the resolution regime is the absence of any amount specifying the deposit insurance threshold in the FRDI Bill, even as it proposes to repeal the existing deposit insurance legislation. In any case, it goes without saying that a substantial enhancement of the maximum insurance amount per depositor is long overdue, since the present limit of ₹1 lakh was set 24 years ago.

Although the government enjoys a comfortable majority in the Lok Sabha, it will be ill-advised to try and use its parliamentary majority to push through a law like the FRDI Bill, which will have grave ramifications for the sensitive financial sector. The underlying thinking behind the FRDI Bill is based on the Report of the Financial Sector Legislative Reforms Commission that advocates, among other things, “ownership neutrality.” This implies that the PSBs compete with private capital in the financial sector, without the “competitive advantage” deriving from the former’s public ownership. The dilution of the explicit and implicit government guarantees for PSBs and financial institutions, however, can only enhance the fragility of the PSBs at a time when the massive accumulation of bad loans has severely affected their balance sheets.

It would be prudent for the government to postpone the establishment of a new financial resolution regime, at least till the bad loans mess in the non-financial corporate sector is cleaned up. Instead, it should apply its mind to devise a resolution regime better suited to Indian financial structures and conditions. 

Updated On : 9th Jan, 2018

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