Mergers no panacea for bank woes: India needs urgent rethink on laws governing financial regulators, separate supervisory and resolution functions

  • The inability to evolve modern resolution mechanisms in India has been consistently noted by international standard-setting bodies for years.

  • Effective resolution frameworks should consist of robust monitoring and reporting requirements separate from regular regulatory mandates, public accountability and timely action without compromising on the critical services provided by such institutions.

  • The now oft used section 47 of the RBI Act, which governs the allocation of surplus profits to the government, lacks procedural clarity and safeguards.

In September 1937, the TNQ Bank was constituted by the amalgamation of two other banks, the Travancore National Bank and the Quilon Bank. The merger was acclaimed locally as the ‘greatest banking amalgamation in South Indian history’. In April 1938, within six months of the amalgamation coming into effect, there was an unprecedented run on the bank. The failure of the TNQ Bank and the banking crisis in South India eventually led to the realisation that the RBI could not simply amalgamate to solve problems. The central bank needed more powers of investigation and supervision. It soon dawned that amalgamation of banks without structural fixes of bank governance would inhibit the central bank to act soundly in times of emergencies.

Last week, the government carried out four big bank mergers with the total number of public sector banks (PSB) coming down to 12. In India, bank mergers have been a common last-minute approach to tackling financial distress. This is facilitated by an absence of a clear, consolidated resolution framework and vague provisions in existing laws. Nearly 80 years after the failure of the TNQ bank, which revealed that bank mergers without tackling the core reasons for bank failures, were bound to reveal less than satisfactory results, it seems like we have learnt nothing.

 Mergers no panacea for bank woes: India needs urgent rethink on laws governing financial regulators, separate supervisory and resolution functions

File image of RBI. AFP

The inability to evolve modern resolution mechanisms in India has been consistently noted by international standard-setting bodies for years. Consider the ‘Thematic Review on Bank Resolution Planningpublished earlier this year by the Financial Stability Board, which noted that out of the 25-member jurisdictions, India and Argentina were the only two countries reportedly without any plans to introduce resolution frameworks.

Why resolution frameworks are important

Resolution frameworks, particularly for large banks and financial institutions are important for several reasons. First, they clarify the mechanisms needed to harness the system from being fixed without severe systemic disruption, or exposing tax-paying citizens to financial loss. Effective resolution frameworks will, therefore, consist of robust monitoring and reporting requirements separate from regular regulatory mandates, public accountability and timely action without compromising on the critical services provided by such institutions.

Second, effective resolution mechanisms separate regulatory function from resolution function. Typically, regulators behave like parents, giving initial licenses to institutions to function, nurturing and monitoring their growth, providing due impetus when they fail. However, once a firm crosses a specified threshold of viability and this is typically at a point where recovery is no longer possible, resolution authorities take over, whose primary job had been, up to that point, to prepare for effective dissolution of the firm, while shielding the economy and taxpayers from further shocks. In short, it allows an independent expert authority, separate from the regulator and the government, in being adequately prepared for the worst-case scenario, such as a financial crisis.

Third, it allows for modern contingency options to be included within the governance framework. This includes a whole basket of mechanisms – protection of deposit insurance during bank resolutions, maintenance of a contingency/resolution fund – paid for by the financial institutions themselves and used for their dissolution, and the judicious use of resolution tools in consultation with the regulator. The reason why resolution frameworks, distinct in mandate and function from regular regulatory frameworks, are important is that they help in the preservation of trust in the system, and allow for a dedicated resolution perspective to be developed. Once a bank or insurance company fails to be viable, the framework kicks in and leads the firm to a respectable and timely death.

Why ad-hoc measures of the Central government undermine the independence

India’s resolution framework can be found within certain omnibus provisions, nestled within various different legislations. However, a closer reading of these statutes reveals that the lack of a dedicated resolution framework is further complicated by over-broad provisions giving undue authority to the Central government, over matters of the regulator. Consider for example section 35 AA of the Banking Regulation Act, which gives the Central government the power to authorise the RBI to issue directions to banks to initiate insolvency resolution processes. Section 19 of the IRDA Act, 1999 gives the Central government the authority to supersede the insurance regulator by virtue of a mere notification.

Similar provisions also exist in the PFRDA Act governing the pensions regulator, and the RBI Act. Section 57 of the RBI Act, for instance, states that the Central government can place the RBI under liquidation by executive order. These provisions, reminiscent of colonial times when the Union government assumed a superior position vis-à-vis a regulator, fail to pass the muster of a functioning democracy today and do not embody the fundamental principle of upholding legislative independence of the regulator in a robust democracy.

The matter gets further complicated when these powers are exercised in times of financial distress and general economic upheaval. The government’s call to invoke section 7 of the RBI Act last year, again a colonial-era provision that had never been used before, is a recent and upsetting example. It is interesting to note that the history of section 7 documents it to be an amalgamation of provisions from the Bank of England Act, 1946 and the Commonwealth Bank of Australia Act, 1945. This was done specifically to prevent the government from acting against the wishes of the governor of the RBI. It was hoped that the use of the provision against the wishes of the governor would be a rare occurrence, and the responsibility of the action would vest solely with the government. The now oft used section 47 of the RBI Act, which governs the allocation of surplus profits to the government, lacks procedural clarity and safeguards.

The lessons learnt

The recent developments in the banking sector – the mergers, the transfer of surplus profits and the invocation of section 7 demonstrate two very crucial things.

One, we need a structural separation of resolution and supervisory functions now more than ever, governing all financial institutions, particularly those that are large and systemic – housed either within the regulator or in a separate institution.

Two, there is a requirement to critically analyse the laws governing our financial regulators. There is an urgent requirement to redraft these laws to make them unambiguous and build guardrails of accountability and transparency in the dealings of regulators with the State. In this regard, the separation of resolution functions from supervisory functions will allow regulators to concentrate on micro-prudential regulations, and vest the case of unviable firms in the hands of a separate functionary, that can act with preparedness and accountability, distinct from both the regulator and the government. This will ensure that bank resolution tools are not restricted to last-minute mergers, and even in such cases, there is public accountability on why the resolution was done, and how, questions that are difficult to ask of the government.

It is important to remember that in 1926, when the Hilton Young Commission recommended the establishment of a central bank – the RBI, in spite of the many controversies on proposals, a unanimous view was taken over the desire to have an independent regulator, free of political influence, to safeguard the interests of the country. It is hoped we don’t lose sight of this history, and of our past learning.

The author is Fellow, Esya Centre.

Updated Date: Sep 05, 2019 10:29:16 IST