Six years ago, when the promoter of a local private bank was in trouble and under pressure from regulators, an influential minister intervened to promote the merger of that bank with another private bank. The promoter managed to cash out on his holdings. But the next time a local bank, insurance company or financial firm is in a similar squeeze, the Finance Ministry, central bank or other regulators may not be involved — if India goes ahead with the promised Code on Resolution of Financial Firms. The Code, announced in the Budget last week, envisages a powerful corporation stepping in much before the lender or financial firm’s net worth (capital plus reserves minus liabilities) erodes — by selling assets, changing the management, even winding up in an orderly way — ensuring there is little impact on the financial system or the economy in the event of its failure.
In the US, this is routine. The Federal Deposit Insurance Corporation or FDIC handled 8 bank failures last year — and as many as 157 in 2010. Over more than seven decades, billions in claims have been settled. Canada has a similar institution, but hasn’t had to deal with a failure over the last few decades. New Zealand has an Open Bank Resolution, under which creditors and shareholders must bear the losses so there is no government bailout of failed banks. In many countries, banks reckoned to be in trouble are placed under statutory management over a weekend, funds are set aside against potential losses, and they open for business the next working day.
Unlike in the West, there is no shuttering of banks in India. Rather, the regulator and government work together to nudge or force a tottering bank to merge with another lender, perhaps prompting some to question whether India needs a resolution corporation.
India has a Deposit Insurance and Credit Guarantee Corporation under the RBI, which is expected to evolve as a strong resolution corporation with the powers to identify firms in the financial sector that could be potential threats to financial stability, supervise or monitor them, and take prompt action. The new structure has to cover state-owned banks and institutions, including the giant insurer LIC, who dominate the financial sector. And this is where the challenges lie. A resolution corporation will succeed only if it is empowered to take swift action — overnight in many cases — without its order on winding up or dissolving of a firm facing legal challenges. That would mean drafting a law to give it the requisite powers, and incorporating changes in other laws such as the Bank Nationalisation Act, SBI Act and LIC Act. That won’t be easy, especially considering hurdles in getting laws approved in Parliament.
Defining the type or size of entities to be covered could pose a challenge too. The RBI has a list of domestic systemically important banks, which includes SBI and ICICI Bank — the ‘too-big-to-fail’ entities whose financial health is critical to stability, and on whom demands are made to set aside more capital. Should co-operative banks, many of whom are under the jurisdiction of state governments, be covered? Or large NBFCs? There is a case for covering co-operative banks, given that a good part of the Deposit Insurance Corporation’s payout is for deposit holders of co-operative banks that have been shut in many parts of the country.
Again, once the resolution mechanism is in place, how will the government deal with a troubled state-owned bank? Can its ownership be transferred to a private investor or entities without triggering the law on government ownership which mandates a minimum equity-holding of 51%, or without conflict with the 10% restriction on voting rights?
The resolution corporation must be well capitalised, so that it is in a position to insure and pay off the liabilities of depositors when a bank or financial firm is wound up, or engage in a holding operation until a buyer is found or assets sold. In most countries, the fund is built from premiums paid by firms that are insured by the resolution corporation, which adopts a four- or five-step approach, including moving in, independent of a regulator, after early warning signs.
Should the government implicitly guarantee it would give support to the corporation? The US FDIC can borrow $ 30 billion from the Treasury; it also has a line of credit from the Treasury. New Zealand does not provide insurance for bank deposits with a policy centred on avoiding taxpayer-funded bailouts. Initial fiscal costs may be high, but this could help prevent contagion in the financial sector which relies on public deposits and involves leverage.
It may be argued that much of the concern over bad loans of banks in India could have been addressed by a strong insolvency law permitting swift sale of assets, change of promoters, mergers or closures without a separate law for financial firms. A resolution mechanism for financial firms can certainly complement the insolvency law. One of the positives of the proposed law is that India’s financial sector regulators are on board. But as the government begins work on this major reform, it has to be mindful of the institutional strength of a new resolution corporation in a political economy like India. Strong legal and political backing and professional capabilities apart, the leadership of the resolution corporation will make a difference. The role will involve huge challenges and conflict — as we saw in the US, where FDIC chief Sheila Bair and Treasury Secretaries squared off over decisions on whom to bail out.