FRDI Bill, 2017: Inducing Financial Instability

The principal objective of the Financial Resolution and Deposit Insurance (FRDI) Bill, introduced in the Lok Sabha in August 2017, is to provide a framework for the resolution of failures of financial institutions, covering the entire financial sector. The bill seeks to establish an all-encompassing Resolution Corporation (RC), which will have powers to acquire and transfer the assets or even liquidate any financial service provider in the case of its probable failure—be it a commercial, regional or cooperative bank, an insurance company, a payment system operator, a Non-Banking Financial Company (NBFC), a mutual or pension fund, or a securities firm. The FRDI Bill also seeks to repeal the Deposit Insurance and Credit Guarantee Corporation (DICGC) Act, 1961 and delegate to the RC, the powers of insuring deposits, collecting premium, and compensating depositors of an insured service provider in case of liquidation.

Presently, the various segments of the large and diverse financial sector in India are regulated by different institutions, like the Reserve Bank of India (RBI) for the banks and the NBFCs, the Insurance Regulatory and Development Authority (IRDA) for the insurance sector, the Securities and Exchange Board of India (SEBI) for securities firms and mutual funds, and the Pension Fund Regulatory and Development Authority (PFRDA) for pension funds, all governed by various acts of parliament. The public sector banks (PSBs), which have emerged as the most dominant financial institutions in India since bank nationalisation, with around 70% share in total banking assets and above 40% share in total financial assets^[1],  are governed by separate legislations as are the insurance companies in the public sector. 

The FRDI Bill intends to amend around 20 of these legislations^[2],  listed in Schedule IV of the bill in order to bring the resolution function in the case of failure of any financial entity under the single umbrella of the RC. 

The management of the proposed RC will comprise of a chairperson, an ex officio member from the union finance ministry, one ex officio member each from the RBI, SEBI, IRDA, and PFRDA, three members nominated by the central government and two independent members. Sections 36 and 37 of the bill provides that the RC will, “in consultation” with the extant regulators, lay down an objective criteria to classify all financial service providers into five categories of “risks to viability”—low, moderate, material, imminent, and critical—based on their capital adequacy, asset quality, management capability, earnings, leverage, and so on. 

Once a service provider falls into the material or imminent risk category, it will have to submit a restoration plan to the regulator and a resolution plan to the RC within a period not exceeding 90 days after such classification. Once a service provider comes under the purview of the RC, its performance will be subject to periodic review and inspections by the RC in order to assess whether it breaches the critical risk to viability criteria. In the case of a difference of opinion between the appropriate regulator and the RC, there are provisions mandating consultations, but the power of final determination rests with the RC. 

The resolution process of a financial service provider can involve transfer or acquisition of assets, merger or amalgamation with another healthy financial firm, liquidation following the order of the appellate tribunal (National Company Law Tribunal), and also utilisation of new resolution instruments like bail-in and creation of a “bridge service provider.” 

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 their size, complexity, and inter-connectedness with other financial entities. The RC will have additional powers in respect of such SIFIs, with their risk assessment, restoration, and resolution being subject to more stringent conditions. 

Bank Resolution in India

Several questions arise regarding the rationale as well as the practicability of such an overhaul of the financial resolution regime in India, which the proposed bill seeks to attain. The official argument that there is no specific, stand-alone law to deal with the failures of financial institutions is not reason enough. In fact, bank nationalisation was initiated in the late 1960s, inter alia, to address the problem of frequent bank failures. Not a single PSB has failed in India since then. Bank failures in the post-liberalisation period have all been of private sector banks, which were compulsorily amalgamated with PSBs to protect the interests of the depositors. 

Five such cases have occurred: the Benares State Bank (BSBL) amalgamated with Bank of Baroda on 19 June 2002; Nedungadi Bank amalgamated with Punjab National Bank on 1 February 2003; Global Trust Bank merged with Oriental Bank of Commerce on 14 August 2004; Ganesh Bank of Kurundwad amalgamated with the Federal Bank Limited on 2 September 2006; and United Western Bank amalgamated with Industrial Development Bank of India (IDBI) on 3 October 2006. Only one commercial bank has faced liquidation—the Bank of Karad in 1992^[3]. 

Several small urban and rural cooperative banks have also faced insolvencies, with the RBI cancelling their licences and the 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. The DICGC balance sheets over the years clearly show that its outstanding liability arising out of the claims of depositors of failed banks, mostly small urban and rural cooperative banks, had peaked at 6.6% of the Deposit Insurance Fund in 2008–09 and has fallen since then to below 1%, 2013–14 onwards (Table 1). The DICGC has accumulated a deposit insurance fund of Rs 70,155 crore till March 2017. 

If anything, this reflects that bank failures in India have become rarer over time in the recent past. The changes in the resolution regime proposed through the FRDI Bill are clearly not being driven by domestic financial conditions.

Global Trends in Resolution Reforms

What has driven the process of regulatory overhaul vis-à-vis the financial resolution regime in India is the pressure emanating from the Group of 20 (G20) and the Financial Stability Board (FSB), which have been setting the financial regulatory reform agenda since the global financial crisis. The “Key Attributes of Effective Resolution Regimes for Financial Institutions” was adopted by the FSB in October 2011, which was subsequently endorsed by the G20 heads of states at the Cannes Summit (in November 2011) as the “new international standards for resolution regimes.” 

While trying to set up an omnibus resolution authority with powers to resolve financial institutions across the spectrum, codifying the processes of resolvability assessments, recovery and resolution planning, and incorporating new resolution instruments like bail-in and bridge institutions, the FRDI Bill has basically followed the template set in the FSB’s “key attributes” in toto.
The FSB’s framework of regulatory reform is itself quite problematic. It starts with the premise that the financial crisis resulted primarily because of the moral hazard problem associated with too-big-to-fail banks. It has, therefore, identified a set of large global banks and financial entities as “globally-systemically important financial institutions,” imposed higher capital standards for them and has put in place a system of monitoring their performance on a regular basis. The preamble to the key attributes document states:

An effective resolution regime (interacting with applicable schemes and arrangements for the protection of depositors, insurance policy holders and retail investors) should... (iv) not rely on public solvency support and not create an expectation that such support will be available… (ix) be credible, and thereby enhance market discipline and provide incentives for market-based solutions. (FSB 2011: 3) 

The FSB expects that the creation of powerful resolution authorities across jurisdictions, with options to either stabilise an unviable financial firm through transfer or sale of assets to a third party and/or taking recourse to “an officially mandated creditor-financed recapitalisation of the entity that continues providing the critical functions”^[4] —bail-in, in other words—along with the liquidation option protecting insured depositors, would address the moral hazard problem involving the giant global banks and financial institutions. 

There is, however, no reason to believe that these “market-based solutions” would deter the banks and financial institutions from indulging in speculative practices during the next asset price bubble, when the rules of the game within the financial markets remain largely the same. Neither is it assured that the higher capital requirements and resolution mechanisms would be adequate in precluding taxpayer-funded bailouts once such bubbles bursts, especially since the already too-big-to-fail global banks continue to grow in size.

However, in the absence of any viable alternative framework given the present geo-political realities, the G20 member states have been pursuing these regulatory reforms in their quest to build a more resilient global financial system. What is noteworthy here is the differential speed as well as combination in which these reforms are being implemented within the jurisdictions of the 24 member-states of the FSB. 

The annual status of implementation reports by the FSB provide information on the bank resolution reforms being carried out in the FSB jurisdictions in terms of the following resolution tools: powers to transfer or sell assets and liabilities; powers to establish a temporary bridge institution; powers to write down and convert liabilities (bail-in); power to impose temporary stay on early termination rights; resolution powers in relation to holding companies; recovery planning for systemic firms; resolution planning for systemic firms; and powers to require changes to firms’ structure and operations to improve resolvability. 

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, some not even implementing the temporary bridge institution provision and so on^[5].  

Therefore, while the advanced economies are clearly pushing this resolution reform agenda, the emerging or developing economies are more circumspect about them, particularly the provisions of bail-in and temporary bridge institution. The other provisions have been implemented in certain jurisdictions, but not in others. The picture vis-à-vis the insurance resolution regimes is even more complicated, with none of the jurisdictions other than Hong Kong, Japan, and the US implementing all the seven provisions compliant with the FSB key attributes. 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.

Resolution Reforms—The Indian Context 

This eagerness displayed by the Indian government in implementing a financial reform agenda in toto, which is suited to the needs of the advanced economies, is difficult to understand. Despite decades of financial globalisation and cross-border capital flows, financial systems across economies still vary quite significantly. 

While the financial system in North American and European countries are dominated by large private banks and financial institutions, it is the public sector which dominates the financial sector in China, India, and many other developing economies. The crisis that engulfed the financial sectors of the advanced economies after the collapse of the Lehman Brothers in 2008 was an outcome of the inherent problems of a privately owned, market-based, deregulated financial system. 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’ JP Morgan Chase ($2.49 trillion) and UK’s HSBC ($2.37 trillion)^[6].  

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 financial systems in India.

Only nine out of the 24 member-states of the FSB have a single resolution authority for resolution of all types of financial institutions. Others have some form of coordination arrangements in place between the different regulatory authorities and only a few have appointed any “lead authority” to coordinate the resolution of domestic entities of the same financial group^[7].  

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. 

The RBI had expressed the view in the “Report of the Committee to Draft Code on Resolution of Financial Firms” that the RC should have the powers to intervene only at a stage when a firm enters imminent risk to viability and leave the ground of material risk for the RBI to cover, through its primary supervisory tool of Prompt Corrective Action (MoF 2016: Annexure II, pp 40–43). Concerns were also raised by the RBI on the potential conflict between its own supervisory risk classification and that of the RC and the power given to the central government to designate the SIFIs in India, rather than the RBI^[8].  The FRDI Bill has not addressed these concerns satisfactorily, leaving room for regulatory conflicts and confusion. 

Another serious concern regarding the creation of an omnibus RC relates to the apprehensions of regulatory capture. 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 the dominance of 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, needs serious reconsideration since they militate against the hard won rights of the employees^[9].  

Deposit Insurance Coverage Limit 

The most serious drawback of the FRDI Bill lies in the omission of the maximum deposit insurance amount. The DICGC Act, 1961, which the FRDI Bill seeks to repeal, clearly mentions in section 16(1) that the total amount payable by the DICGC to any one depositor shall not exceed Rs 1,00,000, with the same section empowering the corporation to raise this aforesaid limit with prior government approval. The maximum insurance amount was Rs 1,500 when the DICGC Act was passed in 1961. This has subsequently been raised five times in the past, the last time being in May 1993. Any government serious about protecting the interests of ordinary depositors would have first and foremost raised this maximum deposit insurance amount, which currently remains at a level fixed almost a quarter century ago. 

The Federal Deposit Insurance Act of the US not only defines the “standard maximum deposit insurance amount” as $250,000 (since April 2010) but also provides for an upward revision of the amount adjusting for inflation, every five years. It is remarkable that a government which is keen to emulate the resolution reforms being carried out within the advanced economies like the US, has overlooked this important provision of the US deposit insurance law, which protects the interests of the depositors. Section 29 of the FRDI Bill, in contrast, merely states that the RC will specify the total amount payable with respect to any one depositor “in consultation with the appropriate regulator.” It is this omission of a specific maximum amount in the FRDI Bill, alongside the provision of bail-in, which has created apprehensions within vast sections of bank customers regarding the security of their deposits. 

A simple adjustment for retail inflation since 1993 (when the Rs 1 lakh deposit insurance limit was set) for the past 24 years would imply that the limit today should not be less than Rs 5 lakh. A comparison with a few selected countries shows that India’s deposit insurance coverage limit to per capita income (at purchasing power parity or PPP) ratio is only around 0.2, which is extremely low by global standards. Not only are the limits much higher within the advanced economies, but emerging economies like China, Brazil, and Indonesia have a deposit insurance coverage limit that is almost five, four, and 12 times its per capita income respectively (Table 3). It is only appropriate that the deposit insurance coverage limit in India be at least twice of its per capita income, which implies enhancing it to Rs 10 lakh. Furthermore, the periodic revision of this amount, adjusting for inflation and per capita income should be mandatory. 

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 Rs 1 lakh and only 1.3% of the term deposits are over Rs 15 lakh; and hence small depositors are adequately covered under the present coverage limit^[9].  This is hardly convincing. First, the suggestion that all depositors with term deposits over Rs 1 lakh are affluent is unacceptable. At the current minimum wage rate of Rs 300 per day for unskilled employees notified by the central labour ministry, the annual income of a family of agricultural workers, who are among the poorest sections of society, would exceed Rs 1 lakh. 

Second, the issue here is not one of small versus large depositors but of the security of bank deposits as a whole, which have historically been the main vehicle in which financial savings of Indian households are parked (Figure 1). The proportion of bank deposits in the gross financial savings of the household sector was around 40% on an average in the 1980s (Table 2). This had fallen to a decadal average of below 35% in the 1990s, with the proportion of shares and debentures and Unit Trust of India (UTI) units increasing from 4% and 2.2% in the 1980s to 7% and 3.8% in the 1990s, respectively.

After the outbreak of the UTI scam in 2001, however, the proportion of financial savings in shares and debentures fell to 4% in the last decade while the proportion of bank deposits increased to almost 45%. The current decade has seen a continuation of the same trend, whereby bank deposits have on average comprised over 50% of gross financial savings while the proportion of shares and debentures have fallen to below 3%. The year 2016–17 has been remarkable because of the extraordinary decision of the government to suddenly withdraw 86% of currency notes in circulation of Rs 500 and Rs 1,000 denomination. As a significant shift in financial savings away from currency was forced upon by the government, the proportion of bank deposits in gross financial savings soared to over 60% in 2016–17, while that of shares and debentures also increased sharply to 10% (Figure 1).

The household financial savings behaviour in India over the last two decades clearly shows an increasing preference for bank deposits, making 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. A significant increase in the deposit insurance coverage limit, particularly at a time when the PSBs have come under stress on account of the accumulation of bad loans over the past decade, would be most appropriate in bolstering depositors’ confidence. 

Implications for Public Sector Banks

The history of financial resolution in India in the period since bank nationalisation shows that public ownership of banks has made a big difference, 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 given the differences in their operational objectives and setting, accountability to the government and the public keeps the PSBs away from risky and speculative financial activities. This is why the confidence of the depositors do not generally erode in the PSBs even with a deterioration in bank financials. 

The RBI has noted that the private sector banks do not enjoy such consumer confidence and during the global financial crisis, deposits migrated from the private sector banks to public sector banks. This led the RBI to conclude that, “the predominance of government owned banks in India has contributed to financial stability in the country” (RBI 2013: chapter 8). 

However, the Report of Committee to Draft Code on Resolution of Financial Firms has taken a completely contrary view of the matter. It has rather blamed the public ownership of PSBs for the “lack of competitive neutrality” in the financial sector: 

For public sector financial firms, an implicit or explicit guarantee by government, and exemptions from mainstream resolution systems, may be creating a perception of safety in the minds of consumers, and an expectation that they will be insulated from the failure of such firms. This has detrimental consequences for competition in the financial system. For instance, in times of crises, there is a flight of funds towards public sector banks and away from private banks, which is a competitive advantage arising solely out of ownership. It is important for competitive neutrality that a level playing field be created between public sector and private sector firms. Among other things, this means application of resolution framework to all financial firms—public and private. (MoF 2016: 14)

This understanding is in line with the report of the Financial Sector Legislative Reforms Commission (FSLRC) headed by B N Srikrishna, which had recommended the setting up of a Resolution Corporation in its report submitted in March 2013. The FSLRC had advocated “ownership neutrality” in the process and choice of tools deployed in the resolution of financial service providers. It is from here that the provisions in the FRDI Bill that seek to amend a gamut of existing legislations governing the SBI, the Life Insurance Corporation (LIC), and other public sector financial institutions have originated. 

An approach that seeks to attain “neutrality” in ownership and competition of financial service providers is fundamentally flawed. Out of the 91,445 bank branches of PSBs in 2017, 32% are in rural areas, while 21% in metropolitan areas. For the private sector banks, only 20% of their branches are in the rural areas, while 30% are in metropolitan areas (Table 4). The shares are similar for the largest banks in each category, the SBI Group and the ICICI. The private sector banks, which accord topmost priority to their profitability, concentrate more on the metropolitan areas to spread their business, while the PSBs with a larger commitment towards financial inclusion have a higher share of bank branches in the rural areas. It should be clear from this that the PSBs and the private banks do not operate with the same objectives.

The efforts to increase financial inclusion by opening zero balance accounts under the Pradhan Mantri Jan Dhan Yojana (PMJDY) brings out the difference between the PSBs and the private sector banks more sharply. Over 80% of such accounts have been opened by the PSBs so far, 16% by the regional rural banks (RRBs), and only 3% by the private sector banks (Table 5). If “neutrality” is not ensured either in terms of their commitment towards financial inclusion or in terms of their operational autonomy vis-à-vis the government, on what basis can “neutrality” be sought between the PSBs and private banks in competition and financial resolution? 

The attempt to attain “neutrality” between the public sector financial institutions and those in the private sector, by bringing them under a common resolution regime is the most retrograde and impracticable aspect of the FRDI 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 sovereign guarantee for insulating 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.”^[11]  

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)], which 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. 

Conclusions

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 the worst possible 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 Financial Security Board given their experiences of bank failures and tax-payer funded bailouts following the global financial meltdown of the last decade, such a reform agenda is not grounded in the Indian realities, where 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 hazardous resolution provisions like bail-in. In order to build a more effective financial resolution regime in India, not only should these potentially destabilising provisions of the FRDI Bill be abandoned, 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.