The FRDI Bill creates a process, with early-warning systems in place to alert regulators and the government about the risk on financial institutions, with which to address and fix failure.
The Financial Resolution and Deposit Insurance (FDRI) Bill, 2017 proposes a mechanism, a method, a path to address potential failures in the financial sector. For a USD 2.3 trillion economy to not have such a system shows a legislative lacuna that the Bill addresses. The question then is: how does the economy manage a bank failure today? The answer, sadly, is: there is no process that a bank or its regulator Reserve Bank of India (RBI) has in place. What we do have is a casual, policy-over-the-evening-snacks approach under which the RBI nudges a large bank to take over the failing bank, as it did, for instance, in the case of the Global Trust Bank amalgamation with Oriental Bank of Commerce [i]. Such spontaneity works for a ‘jugad’-based financial sector; it does not befit a sophisticated and modern economy.
The FRDI Bill changes all this. In a nutshell, the FRDI Bill creates a process, with early-warning systems in place to alert regulators and the government about the risk on financial institutions, with which to address and fix failure. This is important, even crucial, because finally the money at stake belongs to depositors, the money used to make good the depositors’ losses through fiscal largess belongs to citizens — the INR 211,000 crore front-loaded bank recapitalisation to clean up non-performing assets is a case in point [ii]. If the idea is to protect consumers while allowing banks to fail, a process is needed. The FRDI Bill lists out that process.
Through the establishment of a resolution corporation, the Bill attempts to create a framework to resolve distressed financial services providers and to provide deposit insurance to consumers. It covers banks, insurance companies, financial markets infrastructure (payments systems, depositories, clearing corporations and stock exchanges), and systemically important financial institutions (a term that captures size, complexity, volume of transactions and interconnections with other financial institutions). Why are these being resolved separately, when the Insolvency and Bankruptcy Code [iii] (IBC) has already been enacted by Parliament? Because, the IBC looks at resolving companies, partnerships and individuals — it consciously excludes financial service providers [iv].
Through the establishment of a resolution corporation, the Bill attempts to create a framework to resolve distressed financial services providers and to provide deposit insurance to consumers.
The reason is simple. The currency of doing business for financial firms is consumer deposits. By allocating money through complex risk-return expectations to producers, they act as intermediaries between depositors and entrepreneurs. Some of them are systemically important and their failure can disrupt the real economy. As a result, standard insolvency and bankruptcy processes that often drag on for years are not suitable for resolving financial firms. The fears of a failure, for instance, could result in a “run on the bank” even when they have not really failed [v]. Based on the work done by the Financial Sector Legislative Reforms Commission (Report [vi] and Draft Law [vii]) and the High Level Working Group on Resolution Regime for Financial Institutions[viii], a specialised resolution corporation was recommended — the FRDI.
Unfortunately, what is really the first process-based failure management in the financial sector — that is, a method that lays no stress on public finances (getting taxpayers’ money to pay depositors) or on more efficient entities (a stronger bank taking over a weaker one) — is being needlessly debunked. This is being done under the garb of ‘public interest’, even when protections in the FRDI law keep the interests of the public to a higher ground, by law, than the present randomness of good intentions. Most criticism is pivoting around a ‘bail-in’ clause [ix] — a provision cancelling a liability owed by a covered service provider; a provision modifying, or changing the form of, a liability owed by a covered service provider; a provision that a contract or agreement under which a covered service provider has a liability is to have effect as if a specified right had been exercised under it.
In other words, the Bill proposes to give power to the resolution corporation to take part of the money of consumers (deposits in banks, for instance) to keep financial institutions afloat. This clause was put in so that “tax-funded bail-outs become less likely”, and all equally-placed claims would be written down to equal degrees, so that there is equal treatment of similarly placed creditors [x]. But even here, the Bill provides safeguards in the form of options for depositors. “Only those liabilities may be cancelled the instrument creating which contain a provision to the effect that the parties to the contract agree that the liability is eligible to be the subject of a bail-in,” reads Clause 55 (2) (b). In other words, a depositor needs to agree to a bail-in while signing the contract.
The problem here is that banks will not give consumer that option. Worse, being more concerned about stability than consumer protection, there is little hope that the regulator, RBI, would ensure that bank give this option. One way to manage this problem of reluctant banks backed by a consumer-inert regulator is to give added protection to consumers by writing into the final law [xi] that banks give the option to customers, a point that the Standing Committee before which the Bill is pending must ensure. On their part, if banks really want to get around this clause, they could offer a higher rate on deposits where consumers sign up for the bail-in clause, say 150 to 200 basis points higher. So, a senior citizen going in for a 5-year term deposit could get 8.5% if she signs the bail-in clause versus 6.5% if she doesn’t. The differential return is the price of the risk she takes.
The Bill provides safeguards in the form of options for depositors.. The problem here is that banks will not give consumer that option.
On the legal side, the existing protection a bank depositor gets is a maximum of INR 100,000 [xii] for both principal and interest amount held per individual per bank, through the Deposit Insurance and Credit Guarantee Corporation (DICGC) Act, 1961, for which banks pay a premium of 10 paise for every INR 100 of deposits [xiii]. While at more than INR 30,00,000 crore the cover provided by is quite sufficient, the figure of INR 1 lakh per depositor needs revision. For context, the insurance is USD 250,000 [xiv] in US under Federal Deposit Insurance Corporation; it stands at USD 250,000 [xv] through Guarantee Scheme for Large Deposits and Wholesale Lending in Australia, down from USD 1 million till 1 February 2012; and at GBP 85,000 [xvi] in the UK through the Financial Services Compensation Scheme, down from GBP 1 million till 3 July 2015. In India, the insurance guarantee began with INR 5,000 from 1 January 1962. This was raised to INR 10,000 on 1 April 1970, to INR 20,000 on 1 January 1976, to INR 30,000 on 1 July 1980, and finally to INR 100,000 on 1 May 1993 [xvii].
Which means it has risen by a compounded annual rate of 12.7% per annum over the 25 years, from 1968 to 1993. Now that another quarter of a century has passed, this number is in dire need of an upgrade. If we take the same growth rate of 12.7%, it would stand at almost INR 20 lakh. Once the FRDI Bill is enacted into law, one of the first jobs of the new corporation — the Bill proposes to repeal the DICGC Act and amendment of 12 other laws, including Reserve Bank of India Act, Banking Regulation Act, Life Insurance Corporation Act, and State Bank of India Act — must be to raise this minimum guarantee. Irrespective of when the proposed Corporation raises this limit, the government has clarified that the new Bill provides a similar protection to depositors as it exists today [xviii]. So, nothing changes. It has further stated that the “rights of uninsured depositors are being placed at an elevated status in the FRDI Bill compared to the existing legal arrangements over the unsecured creditors and even Government dues.”
In tune with the urge to place systems with which to fix financial institutions on the brink of failure, the Bill proposes objective criteria for classifying the risk to viability they face [xix]. Based on 10 features that include capital adequacy, asset quality and leverage ratios, it classifies the risk on financial institutions under five heads. Low — probability of failure is substantially below the acceptable probability of failure. Moderate — probability of failure is marginally below or equal to acceptable probability of failure. Material — probability of failure is marginally above acceptable probability of failure. Imminent — probability of failure is substantially above the acceptable probability of failure. And critical — probability of failure is substantially above the acceptable probability of failure, and the covered service provider is on the verge of failing to meet its obligations to its consumers.
Financial institutions would be legally bound to share this information with the ‘appropriate regulator’ (RBI for banks, IRDAI for insurance firms and so on). Only once the risk reaches ‘Material’, the Board of the Resolution Corporation enters the picture and the financial firm would provide a resolution plan within 30 days (90 days for systemically important financial institutions). Once the risk reaches ‘Critical’, the Resolution Corporation takes charge. This, without doubt, is a well-thought through Bill.
Low — probability of failure is substantially below the acceptable probability of failure. Moderate — probability of failure is marginally below or equal to acceptable probability of failure. Material — probability of failure is marginally above acceptable probability of failure. Imminent — probability of failure is substantially above the acceptable probability of failure.
But one important point that this Bill overlooks is on disclosures. While the entire edifice of this system lies on financial institutions sharing information with the regulator or the Resolution Corporation or both, all of which is being done in the name of “protecting consumers,” there is nothing in the law that says the information needs to be shared with consumers. The ostensible reason could be that if consumers come to know that if a bank has moved to moderate from low risk, there could be a run on the bank and risk to the system, even when the bank in question is safe. This argument looks down on consumers as worthless economic agents. Instead, what consumers might end up doing is what markets do on ratings downgrades — nobody rushes out to sell the bonds if a rating falls to AA from AAA.
Further, in the hyper-transparent and instant-information world of the 21st century, there is no way to prevent the knowledge of risks from percolating to the public. It is far more efficient for banks and regulators to share information than to consciously suppress it — at stake is the credibility of the entire financial system and the government. From the macroprudential perspective, disclosures are beneficial because they promote financial stability [xx]. Coming to FRDI, every shift in the risk profile of a financial institution must be shared with depositors. If disclosures are the legal and regulatory infrastructure upon which consumers are expected to make intelligent financial choices on the demand side, the disclosure-mandated FRDI Bill needs to provide it to consumers on the supply side as well. This is a clause, if not an entire chapter, the Standing Committee must add to the Bill. If consumers are to be protected, information is their first shield.
[i] Reserve Bank of India Notice: ‘Global Trust Bank Limited (Amalgamation with Oriental Bank of Commerce) Scheme, 2004’, 26 July 2004
[ii] Press Information Bureau, ‘Strong Macro-Economic Fundamentals And Reforms for Sustained Growth’, Part IV, 24 October 2017
[iii] Gazette of India, Ministry of Law and Justice, The Insolvency and Bankruptcy Code, 2016, 28 May 2016
[iv] Gazette of India, Ministry of Law and Justice, The Insolvency and Bankruptcy Code, 2016, 28 May 2016, Part I, 3(7)
[v] Report of Committee to Draft Code on Resolution of Financial Firms, Department of Economic Affairs, Ministry of Finance, 28 September 2016, Page 5
[vi] Report of the Financial Sector Legislative Reforms Commission, Volume I: Analysis and Recommendations, 22 March 2013, Page 69
[vii] Report of the Financial Sector Legislative Reforms Commission, Volume II: Draft Law, Chapter 7, Sections 16 to 19, Establishment of the Resolution Corporation
[viii] Reserve Bank of India, Report of the Working Group on Resolution Regime for Financial Institutions, 18 January 2014
[ix] The Financial Resolution and Deposit Insurance Bill, 2016, Chapter 12, Clause 52 (2)
[x] Report of Committee to Draft Code on Resolution of Financial Firms, Department of Economic Affairs, Ministry of Finance, 28 September 2016, Page 34
[xi] Monika Halan, ‘FRDI Bill’s bail-in clause: Two options for the government’, Mint, 20 December 2017
[xii] A Guide to Deposit Insurance, Deposit Insurance and Credit Guarantee Corporation
[xiii] Initially, rate of premium was fixed at 5 paise per annum for every Rs 100 of total deposits. The rate was reduced to 4 paise from 1 October 1971, again increased to 5 paise, and further to 8 paise from 1 April 2004 and to 10 paise from 1 April 2005: The Deposit Insurance and Credit Guarantee Corporation Act, 1961
[xv] Guarantee Scheme for Large Deposits and Wholesale Lending, accessed on 26 December 2017
[xvii] Annual Report for the year ended 31 March 2009, Deposit Insurance and Credit Guarantee Corporation, Page 2
[xviii] Press Information Bureau, ‘Provisions of the Financial Resolution and Deposit Insurance Bill, 2017 meant to protect interests of depositors, 07 December 2017
[xix] The Financial Resolution and Deposit Insurance Bill, 2016, Chapter 8, Clauses 37 and 38
[xx] Itay Goldstein and Haresh Sapra, Should Banks’ Stress Test Results be Disclosed? An Analysis of the Costs and Benefits, Foundations and Trends in Finance, Vol. 8, No. 1 (2013)
The views expressed above belong to the author(s).