Last week, the Union Cabinet approved the Financial Resolution and Deposit Insurance Bill, 2017, a new framework for dealing with bankruptcies in banks, insurance firms, pension funds, systemically important entities and other entities. At the heart of this Bill is a resolution corporation with a mandate to identify financial firms that are weak and take preventive measures in cases where the net worth — owned capital minus reserves — is positive, or initiate liquidation proceedings and protect depositors, insurance policy holders and others within reasonable limits. This should complement the resolution regime in place for non-financial firms — with the RBI referring 12 big loan defaulters to the National Company Law Board, the Insolvency and Bankruptcy Code, 2016 is now being tested.
The core of this approach, which evolved internationally after the 2008 global financial crisis, is to ensure financial stability, prevent economic disruption and more importantly, bail out banks and financial institutions by using public funds or taxpayers’ money in the hope of instilling greater market discipline. The Financial Sector Legislative Reforms Commission too had recommended such a framework. This was one of the few institutional changes the regulators including the RBI did not oppose. Getting this initiative started should not be difficult. The Deposit Insurance and Credit Guarantee Corporation, an arm of the RBI which insures deposits of up to Rs 1 lakh when a commercial or co-operative bank is liquidated, fulfills the role of a resolution corporation partly, though without the powers to step in early or to act as a receiver. Moreover, India’s case is different from the West. There have been few bank failures in India with recourse to public funds and the banking regulator and the government quick to merge a bank in trouble with a bigger peer. But as the current crisis in the banking industry shows, delays in addressing the operational, financial and other issues of banks pose not just risks to the stability of the financial system but also forces huge infusion of capital, at the cost of social sector spending. Early intervention in such cases is a key to resolution. The RBI putting half a dozen state-owned banks under Prompt Corrective Action points to what could be a new approach.
The new resolution regime and the government’s resolve will be tested when a state-owned bank or institution is notified for liquidation. For, there is the risk of a contagion or a domino effect when a large financial firm fails. The tools available for resolution, besides the ability of the stakeholders to ensure secrecy of the liquidation process, will prove critical to the success of the initiative.