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Towards a new financial resolution regime

LiveMint logoLiveMint 12-09-2017 Joyjayanti Chatterjee

A short story by Ruskin Bond presents a tragicomic scenario of how an offhand remark triggers a chain of events which lead to the near-collapse of a local bank. Nathu, the sweeper boy of Pipalnagar Bank, grumbles about his inadequate and delayed salary to a friend. This fuels rumours about the bank’s financial health which spreads across the small town thanks to the grapevine. The bank’s customers rush to withdraw all their savings from the “failing” bank, the spurt of withdrawals eventually leading to a semi-breakdown. Ironically, the next morning, Nathu, who unknowingly caused the crisis, is left cleaning shards of glass windows, the remnants of the customers’ ire.

The events that transpired in Pipalnagar Bank would be termed a bank run in financial parlance. A bank run is a scenario where a large number of depositors, driven by a severe lack of confidence in the financial system, rush to withdraw their deposits. As banks typically keep only a small percentage of their deposits at hand, a run on deposits or withdrawals can have catastrophic consequences often, actually leading to a crisis. In 1929, after a major fall in stock prices, there were a series of bank runs in the US which gradually precipitated into the Great Depression.

A period of relative calm of 70 years after the Great Depression was followed by the catastrophic crash of 2007-08. The norm of government bail-outs, especially of “too big to fail” organizations, had led to a culture of moral hazard where financial institutions had indulged in a series of risky and speculative practices without due regard to the interests of the stakeholders.

One of the foremost lessons from the events of 2007-08 was that a one-size-fits-all formula simply does not work when it comes to insolvency and resolution proceedings. Financial institutions such as banks, insurance companies, stock companies and clearing corporations have several characteristics which put them on a different footing from non-financial entities like companies and partnership firms. While some financial institutions like banks, insurance companies and pension funds deal with sensitive consumer deposits, others like stock exchanges and clearing corporations are intrinsic to financial markets. Further, because of the increasingly interconnected nature of the modern financial system, a failure in any one sector tends to have a domino effect, which can potentially rattle the entire economy.

As an aftermath of the events of 2007-08, an increasing number of jurisdictions are moving towards specialized resolution frameworks for financial institutions which are characterized by heightened scrutiny and dis-incentivization of excessive risk-taking. The Financial Resolution and Deposit Insurance Bill 2017 (FRDI Bill), which was recently introduced in Parliament, is a positive step in this direction. The FRDI Bill provides for the setting up of an independent new regulator, the Resolution Corporation (RC). The RC will consist of representatives from all financial sector regulators (the Reserve Bank of India, the Securities and Exchange Board of India, the Insurance Regulatory and Development Authority of India and the Pension Fund Regulatory and Development Authority), the ministry of finance as well as independent members.

While the financial sector regulators will continue in their role of prudential regulation and supervision, the RC has been tasked with handling situations of distress in financial institutions. The health of a financial institution will be graded on a five-point “risk to viability” scale, ranging from “low risk to viability” to “critical risk to viability”. The RC’s role in case of a healthy financial institution will be extremely limited, and confined to exchange of supervisory information. For a financial institution which is on the brink of failure, the regulators will work in tandem with the RC in attempting its revival. However, once an institution has failed, the RC will take over and oversee its orderly demise. In order to prevent regulatory arbitrage, the FRDI Bill provides for a clear delineation of roles between the RC and the regulators.

The RC has been armed with various “resolution tools”, which are a mix of traditional methods such as mergers, acquisitions and portfolio transfers and some completely novel ones like bail-in, (setting up of) bridge service providers and run-off. The tool of bail-in utilizes the existing resources of the failing institution by converting debt into equity. However, this tool is not absolute. For instance, only pre-defined liabilities can be bailed in and certain liabilities like those towards depositors and employees cannot be subject to a bail-in. Bridge service provider is essentially a temporary institution which is set up to take over the operations and critical functions of a financial institution, for a period of one year at the most. Run-off is a specialized tool for insurance companies, which allows the present policies (e.g. life insurance policies) to run their course while discontinuing the writing of new business.

In choosing and applying these tools, the RC will be bound by a number of guiding principles and safeguards. A definite time-limit on the process of resolution (one year, extendable by one more year subject to certain conditions) is one of the most notable aspects of the FRDI Bill.

The astonishing recent failure of Otkritie, Russia’s largest private lender, is an example of how fast financial shocks can spread and trigger a domino effect. Financial institutions lie at the very core of a nation’s economy and their failure (unlike the failure of non-financial institutions) has the possibility of bringing the entire financial system down on its knees. The previous financial crises have taught the financial world that a sound resolution mechanism is one that focuses on the consumers of the financial system and ensures that taxpayers’ money is used to the least possible extent. The FRDI Bill is a positive affirmation of this modern philosophy and is geared towards designing a more resilient and efficient financial system.

Joyjayanti Chatterjee is a research fellow at the Vidhi Centre for Legal Policy. Comments are welcome at theirview@livemint.com

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