The Financial Resolution and Deposit Insurance Bill, 2017, introduced in the Lok Sabha this August and subsequently referred to a Joint Parliamentary Committee, has become the subject of much scrutiny and terms such as “bail-in”, “resolution corporation” and “deposit insurance” have suddenly entered social media vocabulary. The FRDI Bill, as it is commonly known, is being made out to be a draconian piece of legislation that would leave depositors’ money without any protection and open to appropriation by the government. Such misapprehension is the result of a selective reading and flawed understanding of the Bill.
Although the intention of formulating a financial resolution law was first articulated in the 2016-’17 Budget speech, the idea goes way back. The need for a strong resolution mechanism, distinct from regulation, was a fallout of the 2008 global financial crisis. It was realised that a one-size-fits-all formula simply does not work when it comes to insolvency and resolution proceedings.
Another point which received a great deal of attention was the peculiar nature of financial institutions. While some institutions such as banks, insurance companies and pension funds deal with sensitive consumer deposits, others such as stock exchanges and clearing corporations are intrinsic to financial markets. Further, because the modern financial system is highly interconnected, failure in any one sector tends to have a domino effect, potentially rattling the entire economy. Therefore, financial firms, because of their very nature, mandate a separate resolution mechanism.
This position is affirmed by reports of some of the most important Indian financial committees of the past decade – the Committee on Financial Sector Reforms, 2009, the Financial Sector Legislative Reforms Commission, 2013, the High Level Working Group on Resolution Regime for Financial Institutions, 2014, the Bankruptcy Law Reforms Committee, 2015, have all recommended a separate law for resolution of financial firms in strong and unequivocal terms.
No bar to liquidation of public sector banks
The tools of resolution currently available to financial regulators in India are contained in a number of laws and they are far from adequate to deal with potential financial crises and protect consumer interests. Further, there is a fundamental distinction between prudential regulation and resolution of financial firms. The Resolution Corporation being set up under the FRDI Bill is tasked solely with resolving failed financial institutions; it has no role in the day to day working of financial institutions such as banks and insurance companies. The Bill provides for grading all covered financial institutions on a five-point scale of risk to viability. The Resolution Corporation has no power as long as an entity is in good financial health and its risk of failure is below acceptable levels.
Most importantly, existing recovery mechanisms of the regulators will continue to operate – for example, the Reserve Bank of India’s Prompt Corrective Action framework – until the penultimate stage. The Resolution Corporation will only prepare for the failure of the concerned entity while the appropriate regulator will continue its recovery efforts.
Only when an entity is classified at “critical risk to viability” – that is, it has failed – will the Resolution Corporation start its resolution, using traditional tools such as liquidation, merger or amalgamation, transfer of assets and liabilities to a healthy entity as well as new tools such as bridge service provider, run-off for insurance companies, and bail-in. The aim of resolution is not to restore the health of a financial institution – this function vests solely with the regulators – but to protect the interests of the people and the financial system in the event of a failure. In fact, even after the Resolution Corporation has taken over, non-conflicting powers of the regulators continue to apply.
This clear delineation of powers between the regulators and the Resolution Corporation provided in the FRDI Bill negates any concerns of the Reserve Bank’s turf – or of any other regulator for that matter – being usurped and their authority being undermined. Contrary to speculation, there is no bar to the liquidation of public sector banks under the FRDI Bill.
Depositors’ money cannot be arbitrarily used
Bail-in is perhaps the most misunderstood clause in the FRDI Bill. A lot of noise has been made about it, particularly the claim that depositors’ money would be used to save failing banks. Bail-in is one of the many resolution methods proposed in the Bill. Bail-in means cancellation or modification of certain liabilities to the extent necessary to recapitalise a financial entity from within. It certainly does not imply this tool can be used at the government’s whim and fancy to arbitrarily use depositors’ money without their consent to save failed banks, contrary to what has been suggested.
Bail-in is circumscribed by a number of conditions and safeguards. It can only be employed by the Resolution Corporation in consultation with the relevant financial sector regulator – the Reserve Bank, in the case of banks. Only that liability can be cancelled where the instrument creating it contains a provision to the effect that the parties to the contract agree to the liability being eligible for a bail-in, and the cancellation will have to respect the hierarchy of claims. Further, only those liabilities can be bailed-in which are specified by regulations to be permissible to be subject to bail-in, and the FRDI Bill provides for consultation with all stakeholders for formulating regulations.
The Bill also provides for a stringent mechanism to ensure the Resolution Corporation’s accountability in the exercise of bail-in. It mandates that no action of the Resolution Corporation, including activating the bail-in tool, must leave any creditor, including depositors, in a worse position than they would have been in the event of the financial entity’s liquidation. In case of departure from this principle, the depositors are eligible for compensation. The Resolution Corporation is required to send to the central government a report explaining why a bail-in instrument is necessary, and the report has to be placed before both Houses of Parliament.
Given the in-built checks and balances, and the strong accountability mechanism, egregious actions such as the conversion of depositors’ money into fixed deposits or refusal to pay money by banks are simply not permissible under the FRDI Bill.
Several media reports have stated that the FRDI Bill signals the end of government guarantees and the end of bail-out. Bail-out is the government’s sovereign right and does not need legislative sanction. Neither does this right need to be enshrined in legislation, nor can it be precluded by one. Therefore, while the FRDI Bill provides for a number of modern, forward-thinking tools that can be resorted to, it cannot and is not taking away the sovereign guarantee accorded to public sector banks.
Deposit insurance will not be withdrawn
There is also speculation that the Bill provides for withdrawing existing insurance for bank deposits. To dispel these doubts, one need look no further than the title of the Bill, which expressly includes the phrase “deposit insurance”. The preamble states that “deposit insurance to consumers of certain categories of financial services” is one of the purposes of the Bill.
The Bill does repeal the Deposit Insurance and Credit Guarantee Corporation Act, 1961, but only to subsume its functioning in the Resolution Corporation. Chapter 4 of the Bill is entirely about deposit insurance and the Resolution Corporation’s liability to insured depositors. The Bill largely maintains the provisions of the 1961 law, while strengthening some clauses, such as providing for faster mechanism of payment of deposit insurance. As far as the deposit insurance limit is concerned, even now the Rs 1 lakh coverage does not arise out of the primary law, the Deposit Insurance and Credit Guarantee Corporation Act.
Originally under this law, the insurance cover was limited to Rs 1,500. It was raised from time to time, eventually reaching the current Rs one lakh. As of March 31, 2017, more than 92 % of deposit accounts were fully insured as they were below Rs one lakh. Beyond this sum, the depositors are considered to be “unsecured creditors”. The FRDI Bill not only retains the protection given to insured depositors, but also accords much greater security to unsecured creditors than the existing law. Fears about deposit insurance cover being withdrawn are thus completely unfounded.
It is ironic that the FRDI Bill is being attacked for not addressing the very ends it is designed to achieve – a specialised resolution framework, a stable financial system, and ensuring the safety of consumers and public funds. While constructive criticism and debate are indispensable to a healthy democracy, critiques based on half-baked knowledge are not only infructuous, but harmful to the dynamic process of law- and policy-making. India cannot dream of ever becoming a truly mature economy, let alone an economic superpower, without establishing a resilient financial system, one that can appropriately deal with contingencies and shocks. Although India emerged largely unscathed from the 2008 crisis, India cannot afford to be caught unawares in the event of a potential financial crisis like many nations were in 2008. Turning the FRDI Bill into law will put India on a par with the nations that learned their lessons from the 2008 crisis.
Joyjayanti Chatterjee, an associate fellow with the Vidhi Centre for Legal Policy, assisted the finance ministry in the drafting of the Financial Resolution and Deposit Insurance Bill, 2017.