The Union government’s decision to withdraw the Financial Resolution and Deposit Insurance Bill, 2017, was based on both formal feedback and informal feedback from the ground.

The draft Bill had been criticised by a wide range of political commentators due to several contentious provisions. One was a “bail-in” concept, which could lead to depositors’ funds being used to rescue failing banks. A second proposal that caused alarm was to continue to restrict deposit insurance – the protection extended to a depositor’s money in case of catastrophic bank failure – to the current limit of Rs 1 lakh of each depositor’s funds. The third controversial proposal was to create an authority, with extraordinary powers, to take decisions in bank failures.

In political terms, the pull back is understandable. If the Bill was made into a law, the Opposition would certainly have accused the government of being anti-poor and anti-middle-class to boot. Given that India is in the throes of a full-blown banking crisis, there is a great deal of public nervousness about the possibility of bank failures. There is also a deep mistrust of the government’s motives after demonetisation. There could have been a run on banks if nervousness built up to a certain pitch, quite apart from the fact that this would be electorally damaging for the Union government.

In economic terms, however, the withdrawal of the Bill leaves a big question mark about the roadmap in case of a big bank failure – a scenario that is certainly not an impossibility.

The RBI’s latest Financial Stability Report, released in June, indicates a massive bank crisis. By March, the non-performing assets ratio stood at 11.6% of all bank loans. The public sector banks, which are responsible for about 72% of total advances, saw their non-performing assets hit 15.6% of their advances by March. Private bank non-performing assets have risen to a more moderate 4% of private advances, from 3.8% in September 2017.

The RBI estimated three scenarios of non-performing assets trends. In a baseline scenario, where macro-economic conditions remain much the same, the RBI projects non-performing assets will touch 12.2% of all advances by March 2019. Public sector non-performing assets will be at 17.3% of their advances. Six public sector banks will be below the required “Capital Adequacy Ratio,” a term we will discuss later.

Historically, RBI baseline scenarios have underestimated future non-performing assets by about 3%. Indeed, the RBI’s severe stress scenario estimates have been consistent underestimates too. Its severe stress scenario of June estimates that the total non-performing assets ratio could rise to 13.3%.

In the medium stress scenario, non-performing assets hit 12.7%.

Even the minimal baseline scenario’s ratio of 12.2% amounts to over Rs 9.3 trillion worth of non-performing assets. That is 6% of the gross domestic product. Banks will attempt to recover what they can by seizing and selling the assets of defaulters. But at least half of the outstanding amount is likely to be unrecoverable. Recapitalisation to compensate for those losses would amount to around 3% of the gross domestic product.

As evident above, most non-performing assets are in public sector banks where the government is the major shareholder. It is not clear if the government can find the funds it requires to recapitalise these banks. As of now, it has only committed to finding around Rs 2.1 trillion via some complicated financial jugglery.

The trouble banks are in

To explain the issues, let us start with a simplified example of how recapitalisation works. Say, a bank has Rs 10 worth of Equity and Reserves (profits from earlier years). This is Rs 10 worth of “Tier-1 capital” or owned funds. The bank also has Rs 100 in the way of deposits and it lends out that Rs 100.

By law, banks cannot lend more than 10.5 times the Tier 1 capital – this is the Capital Adequacy Ratio. The bank charges an average interest rate of 15% from borrowers, while paying an average 5% interest to depositors.

Now, suppose Rs 20 of the Rs 100 loans it gave out go belly-up. The bank receives Rs 12 in interest income (Rs 80 @15%). After paying interest to depositors (Rs 100 @5%) and meeting its other expenses (say, Rs 2), the bank has Rs 5 in profits. It must provision for the bad loans, at rates set by the RBI. That could be anywhere between 20% and 100% of the outstanding, depending on the loan specifics. Let us say, the bank provisions Rs 7 (35%) for that Rs 20 of bad loans. The profit is wiped out and, to adjust for the Rs 2 loss, the Tier-1 capital is reduced to Rs 8. Clear so far?

Now, the bank has multiple future problems. Even if it receives more funds from depositors, it cannot lend out more than Rs 80. To lend more, it must hike the Capital Adequacy Ratio, which means pumping in more equity.

This example is vastly simplified but it should help explain the problems banks are facing. Not only have banks lost money, their ability to give future loans is affected – even if they have funds. Going by what is happening in bankruptcies and enforced auctions of defaulters – for instance the recent case of Bhushan Power and Tata Steel – at least 60% of non-performing assets, perhaps even 75% or more, will be unrecoverable.

Bailing banks out

One clever method of recapitalisation has been deployed in earlier bank crises and will be deployed again. A loan to government (for example, the bank buying a Treasury Bill, or a government bond) is zero-risk and not restricted by Capital Adequacy Ratio.

So, the government issues recapitalisation bonds to the tune of Rs 1.35 trillion. The public-sector banks use their surplus deposits to buy those bonds. Then the government uses the money received to pump in fresh equity and shore up bank balance sheets, while the banks pay interest to depositors.

However, if there is a full-on bank failure, this method of shifting deposits (loans to the bank) to equity may not be enough. So what are the other options?

One option is to buy out a failing bank and merge it with a stronger bank. This could happen – it has happened in the past.

But if a buyout is also impossible, the bank may shut down. In that case, whatever assets are recoverable, are used to give depositors their money back. If there are not enough assets, deposit insurance comes into the picture. Since 1993, bank deposits have been insured to a limit of Rs 1 lakh per depositor per bank (the limit is Rs 1 lakh per entity even if it is split over multiple deposits). The Financial Resolution and Deposit Insurance Bill, 2016, proposed to maintain that limit at Rs 1 lakh, which is far too low, given inflation over 25 years.

Another desperate option is to use deposits to “bail-in” a bank. This involves converting deposits – loans made to a bank – directly into equity shares in the bank. Alternatively, demand deposits or money in savings accounts that can be withdrawn anytime on demand may be converted into fixed deposits or time deposits, which cannot be withdrawn for a while.

The Financial Resolution and Deposit Insurance Bill, 2016, introduced “bail-in” as a concept. Bail-in clauses exist in many banking systems but they are rarely invoked. The last case I know of was in Cyprus. Depositors ended up losing up to two-thirds of their cash when bail-ins were invoked.

The Resolution Corporation

That brings us to the third contentious provision. The Bill intended to create a specialised authority, the Resolution Corporation, to make hard decisions in bank failures. That Resolution Corporation would have sweeping powers, superseding the RBI and even the Supreme Court in some respects. If it authorised a bail-in, or froze deposits, its decisions could not be challenged. Again, given generic mistrust of the government’s motives, and a real fear of corruption or regulatory capture, this proposal led to nervousness.

Instead of withdrawing the Bill wholesale, those provisions could have been tweaked. Simply on the grounds of inflation adjustment, the deposit insurance limit could have been pushed up to Rs 5 lakh (assuming 7% inflation over 25 years). The bail-in concept could have been tightened, perhaps by making government recapitalisation bonds, the preferred option to a bail-in. The Resolution Corporation’s powers could have been curtailed and made subject to stringent review.

Instead, we are back to square one. As and when the government can manage bank recapitalisation, it will. It might take many years for the banking system to recover from this particular crisis. Let us not even get into the underlying reasons for that mass of loans going bad. Such crises will recur, until and unless public sector banks are insulated from political influence, and allowed to reform due diligence processes.