A crisis made worse

Bank employees during a rally in protest against banking reforms in Bhopal on August 22.

On August 10, the government tabled a new Bill in Parliament with the aim of pushing through a desperate policy initiative in the form of the Financial Resolution and Deposit Insurance (FRDI) Act. The Act seeks to create an ostensibly “independent” Resolution Corporation, which would take over the task of resolution of failing financial firms from the Reserve Bank of India (RBI) and other regulators. To that end, it is to be armed with special and near-draconian powers to implement its mandate and will be given control of the deposit insurance framework currently managed by Deposit Insurance and Credit Guarantee Corporation of India.

The context in which the Bill is being introduced needs noting. Financial liberalisation over the last 25 years provided greater freedom for financial firms and reduced oversight by the Central bank. The government, in turn, encouraged public sector banks to use their freedoms and hugely expand their credit volumes so as to spur a private, debt-financed consumption and investment boom. As part of that “strategy”, a significant share of incremental lending went to large corporate players investing in risky projects in capital-intensive areas like steel and infrastructure.

This was a major departure from the more conservative banking practices of the pre-liberalisation era. As a result of the change in behaviour, which exposed public sector banks to liquidity and maturity mismatches, banks accumulated large non-performing assets (NPAs), which in many cases are well in excess of 10 per cent of the advances made by them. Since a disproportionate share of the NPAs are with public banks, the government as owner and the Central bank as regulator are culpable, especially since they had the right to appoint and monitor bank chief executives and keep them pliant.

This culpability was true of the National Democratic Alliance (NDA) and United Progressive Alliance (UPA) governments, both of which backed and implemented measures of financial liberalisation and relied on bank credit as a stimulus for growth, thereby contributing to the increase in the volume of bad debts.

This places on the government the responsibility of helping the banks deal with defaults on large loans. Initially, this evinced two kinds of responses from the government. The first was to help restructure large problem loans through the corporate debt restructuring mechanism, which allowed for longer repayment schedules and reduced interest rates and provided additional credit to tide over the difficult times. Restructured debts could be treated as “standard assets”, absolving banks of the need to provide for these loans and technically write them off. However, in many cases, this merely postponed the bad debt problem at a cost. The second response was to provide budgetary resources for recapitalising these banks to ensure capital adequacy as and when provisioning became unavoidable.

The first of these was resorted to so liberally that the magnitude of the NPA problem remained hidden, with a rising volume of “restructured standard assets” in the books of the banks. When the RBI finally decided to do away with the practice of concealing NPAs, by issuing strict guidelines on the recognition of bad assets, the volume of NPAs in the banking system rose rapidly. The increase meant that the amounts the government had allocated or planned to allocate for the recapitalisation of public sector banks turned out to be grossly inadequate to cover losses. But because the government wanted to meet self-imposed fiscal deficit targets, it was unwilling to suitably increase allocations for recapitalisation.

This meant that other ways had to be found to address the problem of large and debilitating NPAs. As a first new step to address the problem, the government recently promulgated the Banking Regulation Amendment (Ordinance) 2017, which introduced new clauses into the Banking Regulation Act (BRA). These clauses meant that the government could authorise the RBI to take special action to resolve the bad debt problem. This would involve forcing banks to launch proceedings against identified borrowers to recover their unpaid dues. If no agreement for restructuring could be arrived at between the borrower and its lender(s), liquidation proceedings against the borrower were to be launched to recover as much of the loan(s) as possible.

Initially, 12 large borrowers accounting for around a quarter of all NPAs were identified for action. Since then, an additional set of more than 25 borrowers has reportedly been identified. But proceedings at the National Company Law Tribunal (NCLT) suggest that this effort can at best be a partial solution, since, among other things, finding assets that can cover the defaulted loans is not easy. Large write-offs are inevitable. That raises the possibility of bank insolvency, necessitating measures of resolution.

The FRDI Act defines the resolution mechanisms being pushed by the government as an alternative to recapitalisation. At the centre of the new scheme is the creation of a new independent corporation that would take over the task of resolution of bankruptcy in banks, insurance companies and identified “systemically important financial institutions” (SIFIs). The Resolution Corporation will also take over the task of insuring bank deposits, compensating depositors up to a specified maximum amount (at present Rs.1 lakh) in case of bank failure.

As part of its responsibilities, the corporation is to be mandated to classify the financial institutions under its jurisdiction under different categories based on risk of failure, varying from “low” and “moderate” (where the probability of failure is marginally or well below acceptable levels) to “material” or “imminent” (implying failure probabilities that are above or substantially above acceptable levels) and, finally, critical (being on the verge of failure).

In cases of financial firms placed under the material or imminent category, the Resolution Corporation is to be given the power to: (i) inspect the books to obtain information on assets and liabilities; (ii) restrict the activities of the firm concerned; (iii) prohibit or limit payments of different kinds; and (iii) require submission of a restoration plan to the regulator and a resolution plan to it, if necessary involving a merger or amalgamation.

In cases identified as critical, the Resolution Corporation will take over their administration and proceed to transfer their assets and liabilities through merger or acquisition or liquidation with permission from the NCLT. Closing all options, the law prohibits recourse to the courts to stay the proceedings at the NCLT or seeking alternative routes to resolution. Since liquidation involves compensating stakeholders according to their designated seniority, depending on the net assets available, any stakeholder can be called upon to accept a “haircut” or loss, including holders of deposits more than the maximum amount insured against loss.

The implications of this Act are many. To start with, while the Resolution Corporation and the regulator concerned will determine whether a financial firm is to be placed in the “material” or “imminent” category, the task of working out an acceptable restoration or renewal plan rests with the firm under scrutiny. That is, the responsibility of restoring viability is that of the bank, insurance company or SIFI, with the regulation and resolution authority retaining the right to determine whether it has managed to reduce the probability of failure.

Second, since mere categorisation in the “material” or “imminent” category will send out a signal, banks so designated can become the target of a run, as depositors fearing failure would want to move out their deposits. Instead of resolving the problem of vulnerability to failure, the mechanism may actually precipitate failure.

Third, the restoration and/or resolution plan, to be acceptable, may “force” a financial firm to accept amalgamation or merger. This would have implications for parties that are not responsible for the state of the firm, including officers, employees, creditors and small shareholders. For example, retrenchment or downgrading of the status of employees may follow merger and amalgamation. And wherever resolution requires the preferred strategy of “bail-in” of the firm (as opposed to a government “bail-out”), shareholders, creditors and, if need be, depositors, would be forced to accept a “haircut”. The unstated objective of the exercise is to save the government and the regulator from carrying the costs of a “bail-out” of a failing firm.

Thus, the tabling of the FRDI Bill is a clear declaration by the government that it sees painful resolution or liquidation as an unavoidable cost of addressing the bad debt problem that currently afflicts the banking sector. It also makes clear that the Finance Ministry, the Central bank and the government-sponsored regulators will not carry any of the financial burden associated with resolution, but will rather transfer financial and other costs, such as job losses, to employees, officers and shareholders.

Since the problem of potential insolvency is currently concentrated in the public banking system, the government is obviously willing to write off capital already invested, but wants to minimise any additional costs.

Interestingly, as was made clear in the Report of the RBI’s Working Group on Resolution, this resolution framework is merely the replication in the Indian context of a regime recommended by the Basel-based Financial Stability Board (FSB) in its formulation of the “Key Attributes of Effective Resolution Regimes for Financial Institutions”.

The FSB was established in the aftermath of the global financial crisis of 2007-08, which was centred round the United States, the United Kingdom and Europe. However, in those jurisdictions, the resolution of the post-crisis problem of potential insolvency of banks came through government purchases of equity and liquidity infusion by Central banks. The Indian government and the RBI have, on the other hand, chosen to exploit the FSB resolution framework to pursue their own agenda of saving the state at the expense of banks and their stakeholders.