December 25, 2017
Insolvency of financial institutions such as a bank would not only affect millions of households who depend on their savings to spend life but could also start a snowball effect whereby the failure of one bank leads to an immediate, inconsequential collapse of various banks due to this fear. Something similar had happened around the world during 2007-08 global financial crises. That financial crisis highlighted the need for a better resolution of the bankruptcy of financial firms.
The overarching intention is that failure of a financial firm, if unavoidable, should at least be carried out in an orderly manner to safeguard other sectors of the economy. The Financial Stability Board has released guidelines on resolving failures of financial firms; FRDI bill is based on these guidelines.
The major controversy surrounding the bill comes from the “bail-in” clause, whereby the depositors may be asked to give up their deposits to save the bank or any such financial institution from going out of business. This may be subject to the consent of depositors, obtained at the time of deposit. Further, the bail-in amount shall be separate from deposit insurance. Presently, every deposit is insured up to a maximum of ₹ 1 lakh. This limit might possibly increase after the FRDI Bill. Bail-in shall apply only on the remaining portion of the debt.
This contrasts with a “bail-out” where some outside entity (typically, the government) saves the firm from failing by injecting money into it. A bail-out relies on the government’s – that is, taxpayer’s – money.
FSB guidelines, on which the bail-in is based, argue that keeping bailing-out encourages firms to invest recklessly and might increase the risk of failure. A bail-in would ensure that financial firms are cautious about where they invest. Further, a bail-out is akin to transferring the risk from the investor (who willingly chooses to assume risk by investing in a financial firm) to the taxpayer (who has no choice in this matter). It makes sense that the investors should own up to that risk.
But this argument has few takers. In India, depositors include ordinary middle-class people who rely on the banking system for their entire financial support, unlike more mature markets like the USA where dynamic financial instruments are available for investors to choose from. In Cyprus, a similar bail-in clause was invoked, and at that time the depositors lost as much as 50% of their receivables. Subjecting depositors to such a risk may not be prudent, especially because the fault lies elsewhere.
As per the Financial Stability Report of RBI, close to 90% of the total NPAs in banks come from large borrowers with an exposure above ₹ 5 crores. It would be unfair to take up the money from innocent depositors to absorb the losses made by such big firms that are unable to pay their dues. Secondly, unlike in the USA, the depositors in India have little say in the business of the firm.
The bail-in clause is controversial, and both the viewpoints seem to be convincing in their own way. In times of crises, who really bears the loss? As always, such questions are not easy to answer. The focus should, therefore, be on avoiding such a situation altogether, for which strict monitoring and control of the failure of financial firms should be carried out.