FRDI Bill: Why The Bail-In Clause Is Letting In Bad Ideas

The Narendra Modi government inherited an unprecedented level of corporate bad loans – a legacy of the earlier Congress regime. Managing a banking sector that was on the verge of collapse due to the weight of non-performing assets (NPAs) has been a herculean task for the government. Over a short span of four years, however, it has created the necessary legal architecture to prevent organised looting of public money by the powerful. Through the Financial Resolution and Deposit Insurance (FRDI) Bill, it wants to have a framework for the resolution of failures of commercial and cooperative banks, insurance companies, mutual funds, stockbroking companies, and other financial service providers. It was introduced in Lok Sabha in August 2017, after which it was referred to a select committee.

The bill aims at establishing a ‘Resolution Corporation’ with powers to acquire and transfer assets or even liquidate a financial service provider in case of probable failure.

A concern surrounding the FRDI bill has to do with the bail-in clause. Following the introduction of the bill, there has been intense debate over it. A less popular backdrop from which the FRDI bill has stemmed is the proposal to implement a new financial resolution regime by the Financial Stability Board (FSB) of the Group of 20 countries (G-20) in the aftermath of the 2008 financial crisis. The FSB is firm on establishing a regime wherein banks are not bailed out by governments but instead bailed in by depositors. As a member of the G-20, India has made a commitment to bring in legislation to that effect.

Bail-in – a product of the 2008 crisis

As an idea, “bail-in” is essentially a product of the global financial crisis that emerged as an alternative to bailing out failed banks through public funding. During the 2008 crisis, the issue of moral hazard and of bankrupt private banks and insurance companies receiving public funding led to a wider public criticism in the United States (US) and other developed countries. To avoid this problem, the idea of a bail-in was pitched, though it would lead to unwarranted heavy penalties on the depositors.

A bail-in essentially means that deposits beyond the insured amounts could be converted into equity shares of the bank with the consent of the depositor. The depositors then become the shareholders in the bank in addition to becoming creditors. As a result, the equity of the bank would increase and that would help maintain the capital adequacy ratio.

For how long shall taxpayers keep bailing out banks in India?

The lacklustre efforts of previous governments to recover loans are still haunting the banks and also the government. The 21 public sector banks (PSBs) account for 70 per cent of the banking assets in India. Reckless lending, lack of regulatory oversight, economic downturns, and mismanagement of banks has led to a pile-up of NPAs. As of June 2018, NPAs stood at as high as 14 per cent of gross advances of the banks. Of the around 10 lakh crore NPAs in the banking sector, the PSBs account for 80 per cent. The public bail-out between 1985-86 and 2006-07 amounted to Rs 22,092 crore. Nearly half of that amount had been provided in just two years, 1993-94 and 1994-95. The government is infusing capital every year since 2007-08. The taxpayers as well as depositors are in dismay and find no answer as to why their banks are frequently piling up NPAs.

Have neo-liberal reforms failed?

To change the current state of banks, the banking sector reforms introduced in 1991 by the then finance minister Manmohan Singh included deregulation of interest rates, classification of assets, prudential and capital adequacy norms, and infusion of both private and public capital among others. For a while, the reforms appear to have worked. The NPA ratio, which stood at 25 per cent in 1993-94, fell to 2 per cent by 2008-09. Thereafter, that figure increased, and by the end of 2016-17 it became as high as 12.5 per cent.

About 87 per cent of NPAs are with the PSBS. Non-priority sector NPAs rose from 50 per cent in March 2012 to 77 per cent by March 2016. After the liberalisation exercise, Indian banks are lending huge amounts to a few large borrowers who have become defaulters. Compelling them to repay their debt to the banks is the crux of the matter.

Neither the boards nor top managements of banks were ever prosecuted for their lapses and criminal negligence in managing banks, necessitating large-scale public funding. Victimisation of either taxpayers or depositors for the mismanagement of bankers can in no way be justified. In the proposed FRDI bill, there should be a provision for prosecuting top managements and regulators in case of failure on the part of the banks or piling up of NPAs beyond a minimum threshold level.

A bail-in is no alternative to bail-out

A shift from bail-out to bail-in transfers the burden of loss from the taxpayer to the ordinary depositor. When regulators who are mandated to oversee the functioning of the banks are clueless, there is no way an ordinary depositor can regularly monitor the functioning of his bank. Individual savers cannot become effective bank monitors. Besides, ordinary depositors supply cheap funds to the banks. The bail-in process is likely to generate a capital flight which may increase funding costs to the banks. A strong intention to withdraw deposits could be damaging and disruptive not only to the bank concerned, but also to wider market confidence.

Privatisation is no substitute for effective regulation. Unless the regulatory ability of the government is strengthened to monitor the functioning of banks, both private and public, there is no guarantee that the NPA crisis will not recur. The household sector accounts for 68 per cent of deposits in PSBs and about 52 per cent in the private sector. In India, no depositor has suffered a loss so far as no bank is allowed to fail. Insured threshold fixed at Rs 1 lakh in 1978 is the same as Rs 13 lakh now after adjusting for inflation and purchasing power parity.

Restoring credibility

The macroeconomic stability achieved by the Modi government should not be disturbed by policy mistakes. The credit for making India a single market – by bringing in the goods and services tax (GST) – goes to the Modi government. Integrating a larger section of the population into the banking system through the Jan Dhan Yojana scheme is a significant step forward towards inclusive growth. The government is creating the necessary legal framework for fixing corporate accountability. It is not the old game anymore for Indian corporates. Targets have been set for the recovery of NPAs and bank-specific plans are being drawn up to improve the financial health of banks.

At this point, unwavering public confidence in banks is crucial. People trust banks that will safeguard their hard-earned savings. Shifting the cost of systemic failure from the government to the ordinary depositor (bail-out to bail-in) can become a destabilising move. Antagonising the core support base of the party and the Modi government for the sake of the G-20 commitment is unwise politically – that too during election year. Of the 24 members in the G-20, 13 countries – including Australia, China, Brazil, Russia, South Africa, and Indonesia – have not introduced laws to account for the ‘bail-in’ mechanism. Must India rush in where other countries fear to tread?