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Monday, June 27, 2022

In fact: A new law, body to handle failed financial firms

The government will first form a Resolution Corporation, which is expected to cover all firms regulated by the RBI, Sebi, IRDA and PFRDA.

Written by Shaji Vikraman |
Updated: June 16, 2017 1:59:43 am

The global financial crisis of 2008 prompted many countries and regulators to review their financial architecture and come up with a new set of arrangements. These were designed to try and prevent similar failure of financial firms, prevent disruption of the broader economy if large banks and institutions failed, reduce the use of public funds for bailouts of private firms and to promote greater financial stability.

Indian policy makers had to counter liquidity pressures but not tackle the kind of bank failures in the West — especially in the US and UK, where the governments had to use tax-payer funds to protect the interests of depositors, keeping in mind the stability and confidence in the financial sector. In India, after a regulatory squabble in 2009-10, the government decided to recast some of the laws relating to the financial sector, with the Financial Sector Legislative Reforms Commission (FSLRC) coming up with a comprehensive Indian Financial Code, which envisaged an overarching umbrella law for the financial sector across regulatory jurisdictions and a reshaping of the role of the regulators.

While the recommendations were first submitted in 2013, at the fag end of UPA term, key suggestions have been cherry picked by the NDA regime. These include an independent Monetary Policy Committee to the latest Financial Resolution and Deposit Insurance Bill, 2017, which seeks to put in place a resolution framework, to handle bankruptcy or insolvency of financial firms, including banks. The broad aim is to ensure early recognition of a financial firm, regulated by RBI, Sebi, IRDA or PFRDA, which could potentially be in trouble so as to lower the impact on the economy.

India already has a mechanism which is now being put to test for resolving bankruptcies of non-financial firms or companies in the manufacturing sector. The proposed new law for financial firms will complete the resolution process across sectors. What this means is that unlike in the case of the Indian Insolvency Code, which deals with bankruptcies of non-financial firms, the government will have a larger role, with the statutory entity mandated to handle the resolution, which is expected to be the Deposit and Credit Guarantee Corporation, now an arm of the Reserve Bank of India answerable to the sovereign.

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Interestingly, unlike the US where there have been a string of bank failures starting from the 1920s leading to the formation of the Federal Insurance Deposit Corporation, the only payout by the DICGC in India was after the Madhepura Co-operative Bank went bust well over a decade ago.

The deposit premiums collected by the Corporation have swelled over the years as the Indian central bank and successive governments have chosen to amalgamate a failed bank with a healthier one given the risks of contagion or of depositors making a run for their money.

In theory, the proposed new law appears to be a bold experiment. But the challenge could be when it is put into practice as we are now seeing with inflation targeting through the Monetary Policy Committee. It also signals in some ways a departure from some jurisdictions — like in the UK, where after the 2008 crisis and the resultant review, the Bank of England is the resolution authority. The Indian government’s latest move will also signal the gradual transformation of the Indian central bank from a full service bank — handling regulation to monetary policy and other areas — to an inflation fighting one.

Can a resolution for financial firms work without a separation of regulation or should regulation of financial firms and resolution of insolvencies or bankruptcies of such firms be handled by the same authority? Should banks be treated on the same footing as other financial firms when it comes to resolution, considering that they are in many ways special given that they can leverage based on depositor funds and function in ways different to other financial intermediaries.

From the government’s perspective, this mechanism could well help in terms of lower infusion of funds or capital each time a bank totters or is on the brink. It comes at a time when half a dozen banks have been put under Prompt Corrective Action by the RBI.

Critical to the success of this initiative later will be the speed at which the Corporation, the regulator and the government move to act. That would mean in case of a failed bank at the last stage, moving in on a weekend and ensuring that depositors get their cheques as soon as banking business kicks off on the next working day, without any disruption. That will call for a great deal of secrecy and efficiency. More than that, it will be a test of India’s political economy — of whether the government can stand firm on pressures when it comes to deciding on which bank or institution to let go.

As Andrew Haldane, the Bank of England’s Chief Economist, said in a speech well after the financial crisis: “To ask today’s regulator to save us from tomorrow’s crisis using yesterday’s tool box is like to ask a Border Collie to catch a frisbee by first applying Newton’s law of gravity!”

What is the financial resolution Bill all about?

When a bank, an insurance company or a NBFC is in trouble, with little hope of being revived, the current framework makes it extremely difficult to close it down. Take the case of a bank. Even when there is a substantial erosion of capital of a lender, more and more capital is infused into such an entity, rather than assessing whether it needs to be closed down. That’s because of the worry of a systemic risk — the impact on other banks when reports emerge of a bank being shuttered. The proposed law aims to identify such financial firms early on and, through a Resolution Corporation, work on a quicker way of resolving it — either through a merger, sell off or winding it up.

How will this work?

The government will first form a Resolution Corporation, which is expected to cover all firms regulated by the RBI, Sebi, IRDA and PFRDA. This Corporation will take swift action for winding up or dissolving a firm. Once that happens, the Corporation will act like a receiver — ensure quick payments to depositors up to a certain limit to which their deposits have been insured and settle the claims of debtors and equity holders. It will have a corpus or fund built on premiums by firms which are covered under the new law, besides contributions from the government.

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