Meera Nangia, professor of commerce at the University of Delhi in The Wire:
“The declining profits are indicative of the persistent efforts by banks in the last two years to recognise the extent of irrecoverable loans. Simultaneously, banks are undertaking fresh initiatives to liquidate bad loan accounts. The government too is keen to facilitate this process of recovery from defaulting borrowers. The new Insolvency and Bankruptcy code was notified on May 28, 2016.
[Lila: Referenced in the Edmond de Rothschild memo, previously mentioned here.]
Effectively, demonetisation has ensured that the cash lying outside the banking system (given our predominant cash economy and the parallel black economy) is now within the banking system, in the accounts of the customers to whom it belongs. The government campaign on digital payments is ensuring that banks remain flushed with liquidity. Liquidity implies that banks can keep a small ‘fraction’ of the deposits as reserve, and lend out the rest to credit-worthy borrowers.
However, credit off-take is likely to be slow since it will take time for the demonetisation hit economy to take off. It will take a long time for the banks to make profits that can completely wipe out the losses on account of NPAs. In the coming year, as banks net their losses, there will be greater clarity about the exact amount of fresh capital required by banks. The State Bank of India is already working out the scheme of a merger with its five associate banks subsequent to the cabinet approval in June 2016.
This brings us to the next logical question – where will this fresh capital come from? There are many options – equity shareholders of the bank can invest further into the bank, the government can provide fresh capital, weak banks can be merged with strong ones, or in the worst case scenario, a bank can be declared insolvent (central government is empowered to declare state-owned or nationalised banks insolvent). However, it is not easy to find an investor for a failing bank. In case of liquidation, there are established principles regarding the priority in which losses are borne –secured creditors get the best deal, the unsecured creditor also bears the brunt of failure but the equity shareholders bear the maximum loss.
Perspective from international finance
In 2008, the global bank crises threatened the very existence of the financial system. Simultaneously, the outcry against ‘bail outs’ using public funds gained momentum. There could be no rational justification for the government to tide over irresponsible banks. Since then, there has been a sea change in the collective thinking of central bankers all over the world. The Financial Stability Board (FSB) was set up in 2009 to ensure that banks never fail.
It believes that a failure of banks destabilised the financial system and hence banks must never be allowed to fail. India, as a part of the G-20 group at the Brisbane summit in 2014, endorsed the FSB proposal ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’ that recommends ‘bail in’ to ensure the stability of the financial system. The first test run of the bail-in strategy for insolvent banks was launched in Cyprus in 2013.
India does not have the complete legal architecture necessary to implement this new international standard. However the committee set up by the finance ministry to draft the Financial Resolution and Deposit Insurance Bill 2016 submitted its report on September 21, 2016.
The report acknowledges “the committee studied guidances issued by the financial stability board and to the extent suitable, drafted the Bill to be consistent with the key attributes given in those guidances.” It envisages the setting up of a Financial Resolution and Deposit Insurance Corporation (FRDIC) that have the objectives of contributing to the stability and resilience of the financial system, protecting consumers up to a reasonable limit and protecting public funds, to the extent possible.
In case a bank “reaches the stage of imminent risk to viability” the FRDIC will have, amongst other things, the power “to exercise any of the tools to resolve the firm – sale to another financial firm, the incorporation of a bridge institution, or bail-in”.
‘Bail in’ and the unsecured depositor
On the face of it, setting up the FRDIC appears harmless enough – a mere streamlining and simplification of existing procedures. In reality, it aims to reorient the role of the RBI from supervision and regulation to financial stability. Since the primary concern will be financial stability, the fiduciary responsibility of the RBI, presently endowed under the RBI Act 1934 to protect the depositor, is automatically curtailed. The RBI would be taking the path trodden by other central banks in the world who have sacrificed the interests of the depositors in favour of fellow banks and corporates.
The mechanism of ‘bail in’ is recommended when a bank has failed, but it must be saved since its services are considered necessary. Under the FSB proposal, the resolution authority also has the power to impose a moratorium and suspend payments to unsecured creditors. In simple terms, this means that the money belonging to the unsecured and uninsured creditor can be used to save a bank from bankruptcy. The failing bank can be recapitalised with depositors money and without their consent as well. The new enactment grants sweeping powers to the resolution corporation.
When we deposit money in a bank – seldom do we think of ourselves as creditors. In fact, we are unsecured creditors of the bank. In case a bank fails, we would lose our deposit because the bank does not give us any tangible security against this deposit. However, in India, the Deposit Insurance and Credit Guarantee Corporation insures our deposits to a maximum of Rs 100,000 per deposit account in a bank. So, if a customer has a deposit of Rs 150,000 in his bank account and the bank fails, then the excess of Rs 50,000 is uninsured and the customer has no legal remedy to recover this amount.”