FRDI Bill: Dispelling some myths about bail-in and other issues to allay depositors' concerns
The FRDI Bill proposes to create a framework for overseeing financial institutions such as banks, insurance companies, non-banking financial services (NBFC) companies and stock exchanges in case of insolvency.
The Financial Resolution and Deposit Insurance (FRDI) Bill proposes to create a framework for overseeing financial institutions such as banks, insurance companies, non-banking financial services (NBFC) companies and stock exchanges in case of insolvency.
The 'Resolution Corporation', proposed in the draft bill, would look after the process and prevent the banks from going bankrupt. It would do this by "writing down of the liabilities", a phrase some have interpreted as a "bail in".
The draft bill empowers Resolution Corporation to cancel the liability of a failing bank or convert the nature of the liability.
Finance Minister Arun Jaitley recently said the government's massive Rs 2.11 lakh crore capital infusion plan in banks was to strengthen banks and there was no question of any lender failing.
Here is a ready reckoner:
What is bail-out?
Bail-outs mean injection of funds into a distressed financial institution, most typically done by Governments. The first major bail-out of a ‘too big to fail’ bank happened when the US government recapitalised the Continental Illinois Bank in 1984. Bail-outs can happen through capital injections (state funds injected into the bank in exchange for shares), and/or through government guarantees to third parties some or all of the liabilities of the failed bank, and/ or through government guarantees to the failing bank itself the value of some the bank’s doubtful or distressed assets.
What is bail-in?
Bail-in was a tool developed post the global financial crisis, in response to developing a tool of resolution that would give the benefits of a bail-out, but at a lower or no cost to the common tax-paying person. The tool is to be used in conjunction with other resolution tools. Very simply put, the tool seeks to recapitalize a failing institution by writing off some or whole of its debt, and converting debt into equity. This has an impact on the bank’s balance sheet (due to reduced interest liabilities on the debt). If debt is converted into equity, the bank sees an increase in its capital, again meeting regulatory capital requirements. Thus, debt holders become equity holders.
Can bail-in be used to convert all debt into equity, or cancel all debt?
No, while there are jurisdictions which allow statutory compulsory bail-in, including the EU, the UK, and the US, in India, the now controversial Financial Resolution and Deposit Insurance Bill, 2017 (FRDI) does not allow this. It states that the only those liabilities 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 in advance, to be permissible to be subject to bail-in. Drafting of any such regulation will be done with the regulator (RBI for banks), and be subject to public consultation.
Why is it useful?
Regulators across the world see it as integral to addressing the ‘too big to fail’ problem, since for large banks and other large financial institutions, it is not in the public interest for them to enter insolvency due to the interconnectedness of the banking system (the insolvency of one bank can cause wide spread problems in financial markets) and the range of essential services they provide to customers and other industries. Disruption to these services could have serious repercussions for the economy. Doing so optimises the prospect of salvaging the viable part of an institution. The tool of bail-in becomes most advantageous when resolution authorities fail to find a willing buyer for a failed financial institution, and effecting a full or partial transfer of the firm proves difficult.
Will my deposit insurance be taken away?
No, the maximum amount of money that is insured on a single deposit in a bank is currently Rs. 1 lakh. This amount was fixed years ago, and the FRDI Bill does not seek to reduce the amount, and rather increase the limit. Deposit insurance money, pension liabilities, liability in lieu of holding client assets etc. are explicitly excluded from the purview of bail-in.
So are my bank deposits safe?
There are a number of checks against the arbitrary use of this tool. First, the Resolution Corporation can only use the tool in consultation with the regulator. Second, this tool can only be used prospectively, that is, in the future, either on classes of liabilities that are specified in regulations in the future, or on instruments where parties in the future will agree to some liabilities in the future. Third, the Corporation will have to send a report to the Central Government, to be laid in Parliament, explaining why a bail-in instrument was necessary in a particular case. Fourth, if any creditor, including a depositor receives any money on account of bail-in, which is less than what they would have received during liquidation, then they will be compensated for the difference. Hence, bank deposits will not be touched, even with the passage of this Bill.
Is bail-in the solution to all problems?
No, bail-in is an essential addition to the resolution toolkit. However, to manage a financial crisis, what is needed is a comprehensive resolution regime, along with a prudent regulatory framework.
Are our banks, specially our public sector banks safe?
Yes, our banks are safe, and so are our deposits. The safety and recovery of our banks continues to be in the domain of the RBI. The new Bill simply puts in place a regime to manage failure when all else fails. The objective of the Bill is to protect depositors and consumers of the financial system, and ensure that our financial economy does not crumble when a crisis hits. If required, the Government will always bail-out our banks and keep our deposits safe.
However, the aim is not to incentivise big banks to take excessive risks and bank on the government to save them. This creates a very toxic, cyclic environment of taking risks, and asking the government to save banks using our tax money. This is exactly what happened in the global financial crisis. Thus, the aim is to step up the monitoring on these banks, and design a legal framework to manage failure effectively, if and when it happens.
Bail-in does affect shareholders’ and creditors’ property rights. But resolution authorities may only use resolution tools — including bail-in — when this is necessary, with regard to the public interest. And no creditor will be worse off following a bail-in than would have been the case had the whole firm been put into insolvency.
(The author is Senior Resident Fellow (Corporate Law and Financial Regulation), Vidhi Centre for Legal Policy. She helped draft the Financial Resolution Bill)
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