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Why India shouldn’t use the ordinary depositor’s money to rescue banks

Reuters/Ajay Verma
Sparking chaos.
By Charan Singh

Faculty, Indian Institute of Management, Bangalore.

This article is more than 2 years old.

The depositors of India’s commercial banks are worried about the Financial Resolution and Deposit Insurance Bill (FRDI), 2017, which was tabled in Parliament in the last monsoon session and was expected to come up for discussion during the current winter session. Even though the bill has been deferred for now and should come up for hearing next year, concerns remain.

The fear is especially regarding Section 52 of the bill which mentions that a depositor’s money, among other things, can also be used in the resolution mechanism for banks.

The alarm seems unfounded and premature as the bill is still to be discussed in the parliament, the method of resolution of non-performing assets is yet to be finalised, and the Resolution Corporation (RC), only relevant for failed financial institutions, has not even been established—all pre-conditions before a depositor’s money can be appropriated.

According to the bill, the RC has the authority to resolve the stressed assets of firms by various means, including a bail-in or a combination with other methods. Traditionally, the resolution of stressed assets can be through support from outside of the bank, like resorting to recapitalisation from the budget. These are known as bail-outs, and have been standard practice in India. The other option is the utilisation of in-house resources, or a bail-in, as is being proposed now in the FRDI bill.

However, the bail-in clause, though internationally accepted, may not be appropriate for India’s banking system.

Two sides

In emerging economies, banks play an important role in financial intermediation. In fact, in view of under-developed financial markets, banks are the main source of finance for industry and commerce, especially small and medium enterprises.

At the current stage of growth of India’s financial system, a bail-in clause will encourage shadow banks and defeat the purpose of demonetisation, where substantial amounts of cash was deposited in the banking system. Progress under the government’s financial inclusion initiative can also reverse if people have the fear that their money is not secure in a bank. A bail-in clause, therefore, can scare the depositors and redirect their savings back into gold, land, chit funds, and even cash.

Yet, the bail-in regime has been used in some countries. Particularly in the G-20 bloc, it is considered a viable option for resolving stress in banks where non-performing assets are rising. In the case of the US, there is a detailed and credible legal framework for bail-in resolution under the Dodd-Frank Act, 2010. Similarly, in the case of Switzerland, a contractual bail-in regime is fully established, including the assessment of loss-absorbing capacity of banks and financial institutions. Globally, the issue had been deliberated at the Financial Stability Board in October 2011 and adopted with additional guidance in October 2014.

In India, traditionally, stressed public sector banks (PSBs) have been supported by taxpayers through recapitalisation from the government. And this government support has been getting larger over the years. In many instances, it has clearly been established that the rising level of stressed assets is due to defaults by large industries. Consequently, as argued by chief economic advisor Arvind Subramanian, stress in the corporate sector gets transmitted to banks—a twin deficit concept.

This bail-in resolution mechanism to resolve the stress of banks caused mainly because of a lapse on the part of large industrial units by using innocent depositors’ money seems inappropriate. On other hand, it can be argued that using resources contributed by taxpayers who are not related to stressed banks is also unfair. Rather, depositors benefiting from the existence and continuation of their respective bank should be the first to bail the financial institution out of a crisis.

Not for India

In India, bank deposits are insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC), which was set up in 1961. The amount insured by DICGC per depositor in a respective bank has varied over the years and has been Rs1 lakh ($1,555 ) since 1993.  The RC, when it comes into existence, can reset the insured amount in consultation with the RBI.

The public fear is that after demonetisation a substantial amount of cash has already been deposited in bank accounts and, therefore, the balance outstanding is generally higher than Rs1 lakh. After all, the main purpose of depositing money in banks was safety and liquidity, and if the government appropriates it through the FRDI, then what alternate savings avenue is available for innocent and honest taxpayers?

India still has limited financial instruments for various categories of investors, and deposits in banks offer the only investment opportunities for many people, especially elderly, retired, and vulnerable sections of society, like widows. Similarly, for people lacking financial literacy, bank deposits are the only instruments that offer returns on savings. Bank deposits are popular in rural areas because of a lack of alternate opportunities like mutual funds or stock markets. Further, given the small size of savings of the majority of citizens, the deposit schemes of banks seem an attractive option.

But are these fears justified in the context of India where the public sector characteristics of state-owned banks are zealously guarded?

The PSBs were established to serve unbanked and vulnerable sections of society. The social obligations of the government since 1967, like priority-sector lending, have been successfully carried out through the PSBs. In fact, the record-breaking initiative of Pradhan Mantri Jan Dhan Yojana was spear-headed by the PSBs. Therefore, perusing historical developments, it seems that fears are without foundation because government has repeatedly been recapitalising the PSBs, to ensure and enhance welfare of the poor, vulnerable, and weak.

Yet, this bail-in provision utilising depositors money may not be a good fit for India. This provision may seem appropriate in countries where financial literacy is high and banks are mainly in the private sector, like those in G-20 countries. The regime would work well where depositors of listed private banks have a say in management and governance and, therefore, can be held accountable if wrong investment decisions have resulted into a stressed situation.

In the PSBs of India, where depositors neither have a say in management and governance, nor in issues related to investment and credit, a bail-in using depositors’ money seems to be an inappropriate tool for a resolution mechanism.

In an emerging country like India, where financial instruments are scarce and alternatives like financial markets aren’t developed, a bail-in as a resolution mechanism should be avoided. And in case bail-ins necessarily have to be tapped, then deposits of vulnerable sections like the elderly, retired, and widows should be explicitly exempted from the resolution mechanism.

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