FRDI is not the answer to banking woes

There has been some heated debate on the “bail-in” clause (Clause 52) of the Financial Resolution and Deposit Insurance (FRDI) Bill, 2017, presented to the Lok Sabha recently. There have been apprehensions that the clause as specified in the Bill is against the depositors’ interest as in the event of a bank failure, the deposits kept with the banks will be used to “bail in” banks (as opposed to a “bail-out”) to absorb the losses incurred and will not be available to the depositors.  Alternatively, the deposits will be converted to equity or debt as the proposed Resolution Corporation will decide in consultation with the Government of India and Reserve Bank of India. It may be of interest to mention that in the aftermath of the global financial crisis of 2008, the US and UK had made similar provisions for their financial firms. Understandably, public reaction in India has been sharp, forcing the finance minister to remark that the government will fully protect the deposits. He added that the run on the deposits will not happen as public sector banks will be well capitalised after the injection of Rs. 2.11 lakh crore in to the PSU banks. Not many will buy the assurance at this stage.

The FRDI Bill will establish a “Resolution Corporation” to oversee financial institutions such as banks, insurance companies, non-bank finance companies and stock exchanges in case of insolvency. The bill is thus complimentary to the “Insolvency and Bankruptcy Code” introduced for the non-financial companies. In one argument, the Bill carries the potential of   strengthening the financial stability as the “Resolution Corporation” will monitor banks by analysing the risks of failure and resolve them in the event of such failure. With the establishment of this Corporation, the Deposit Insurance and Credit Guarantee Corporation(DICGC) wholly owned by RBI will be disbanded. The compensation to the depositors have not been specified in the Bill; however,  it is expected that the compensation will be around Rs. 1 lakh as it is currently given by the DICGC as insurance against deposits of a bank that might have failed.

The Bill will be referred to the Joint Parliamentary Committee (JPC) for further examination.  A few contextual issues: first, the Indian financial sector is well- regulated unlike the case of advanced economies in the pre-crisis period.  Currently, the multiple regulators (RBI, SEBI, IRDA) have role clarity even if it is argued that they may not execute that role or responsibility as well as the regulators are expected to. However, it is not clear how and to what extent the Resolution Corporation will be empowered and how the coordination among the regulators will be done. Lack of role clarity may create problems in terms of supervision and monitoring. Second, the “bail-in” clause is a major psychological irritant as it is subject to judgements on whether deposits should be used for strengthening the capital base or conversion to a new security like debt or equity. Furthermore, since our banking system is well regulated and well capitalised, as is being claimed by the authorities, why would any sane government make the depositors nervous with a “bail in”?

Nervous depositors, primarily households, may prefer to divert their savings from bank deposits to gold and real estate. This could result in a decline in financial savings and thus will further fuel the growth slowdown process.  One option could therefore be to omit Clause 52 which contains the provisions for a “bail in”.  But exercising this option does not address the cause of bank failure; it only addresses the symptom. Third, the “Resolution Corporation” as the Bill specifies, will classify the financial firms under five categories based on their risk failure. These include: (a) low, (b) moderate, (c)material, (d) imminent and (e) critical.

The root cause of our problems in the banking sector is the governance of PSU banks and banking sector reforms. Banking sector reforms do not necessarily mean privatisation of banks but improvement of governance and strengthening competition.

The “Resolution Corporation” will take over the management of a financial firm once it is classified as “critical” and it will resolve the firm/bank within one year, which may be extended by another year, This looks theoretically sound as it has text book characteristics. But it is not a pragmatic approach because risks to failure are structural and therefore, merger or acquisition, transferring the assets/ liabilities/ management to another firm or liquidation critically hinges on an efficient financial market development for appropriate price discovery. The better option instead could be introduction of a rating for the PSU banks in terms of these five categories. This will lead to transparency and depositors accordingly can switch their deposits.

Nervous depositors, primarily households, may prefer to divert their savings from bank deposits to gold and real estate. This could result in a decline in financial savings and thus will further fuel the growth slowdown process. 

The root cause of our problems in the banking sector is the governance of PSU banks and banking sector reforms. Banking sector reforms do not necessarily mean privatisation of banks but improvement of governance and strengthening competition. It will not be out of place to mention that the current large and growing NPAs are a product of weak governance and apathy towards competition. The Indian banking system and particularly PSU banks would undergo a revolutionary transformation if they are to finance huge infrastructure needs of the Indian economy. We may revisit some of the options put forth by Dr. Raghuram Rajan,  former Governor of RBI, which include (a) constitution of the Bank Board Bureau(BBB) and over time BBB transforming in to a bank investment company (BIC), (b) enhancement of in-house expertise, particularly in project finance, credit evaluation, technology upgradation  with recognition to talent and less importance to consultants as the latter may be biased, (c) emphasis on customer service and customer-centric advice and (d) incentive structures for the bankers should be worked out to encourage them to evaluate, design and monitor the projects.

The banking sector reforms, mitigation of NPA and improvement of bank balance sheets should get precedence over the implementation FRDI 2017. Or else it would be like putting the cart before the horse.