FRDI Bill: A ‘Bail-In’ Clause Shouldn’t Become a License for Irresponsible Banking Practices

A bail-in should never be carried out as a means of complying with BASEL norms.

Recent news of bank NPAs and recapitalisation of public sector banks through bailouts – whether it is through budgetary allocation or the issue of bonds – has evoked much debate. The failure of banks, a development that has over the years reared its head globally, is a largely unknown phenomena in India,

To deal with such situations in future the government has introduced Financial Resolution and Deposit Insurance (FRDI) Bill, 2017. It was referred to a joint parliamentary committee this August after cabinet approval. The bill covers bankruptcy of businesses such as banks and insurance. It proposes a mechanism for financial resolution in cases of banks facing ‘material’ or ‘imminent’ risk to viability depending on their capital and asset worth.

This bill introduces the provision for a “bail-in” whose purpose is to provide capital to absorb the losses of a bank and ensure its survival. The bail-in provision empowers the proposed Resolution Corporation to cancel a liability owed by the bank or change the form of an existing liability to another security and the surplus generated by reducing the liability be used for recapitalization of the bank. The liability of a bank includes deposits of various kinds. The bank promises to repay the money when demanded by the customer. Since the customer has not taken any security from the bank when handing over his money, legally, the customer is an unsecured creditor of the bank. With a ‘bail-in’, the bank can refuse repayment of a customer’s money or instead issue securities such as shares to a customer. This is in lieu of his deposits which are then used for recapitalisation of the bank.

The concept of bail-in was first tried in Denmark. In its response to its financial crisis in 2011, the country came up with five bank packages which included increasing the cap of the insured amount deposited in banks, along with a safety net. During the Bank package III – bail-in was implemented for a bank and imposed losses on senior debt holders. Further it was formally proposed in an IMF working paper in 2012. In 2013, in Cyprus when it witnessed the collapse of its banking system. Banks were shut overnight, people were left with no access to their money and the government refused to step in and bailout. Cyprus, then, became the testing ground for the bail-in programme. In short, it was a disaster, what can only be called the ‘legal theft’ of depositor money.

In India there has been much debate on what will happen to deposit of bank customers once the bail in-provisions are operative. What needs to be understood in the present context is that even without ‘bail in’ provisions the deposits of customers are only currently secure upto Rs 1 lakh, the money insured under deposit insurance. Beyond that, technically speaking, the money is legally not safe and banks can always refuse to pay it. The money can be saved only with government intervention. Naturally, governments try to do this because credibility of the banking mechanism is important – banks after all are intermediaries who help channelize savings to industry and investors.

However, by concentrating the debate on the question of amount of insurance when it comes to the balance of depositors, a more important aspect has gone undiscussed. To properly appreciate the issue it needs to be noted that there are important global norms that set a common standard for banks across countries. These global norms are called the BASEL norms, originally set in 1974, the most recent set of norms, called BASEL III, are to be implemented in India from 2019.

These norms mandate that you need to have a minimum capital of 10.5 percent of banks risky assets. However, keeping in view the fact that banks are crucial for working of any economy, and in a capitalist economy profits are important therefore the BASEL norms provide an easy way out to meet the capital requirement. It says Tier 1 capital – the main portion of the banks’ capital, usually in the form of equity shares – should amount to 8% of the banks’ risks. So, if the bank has risky assets worth Rs 100, it needs to have Tier 1 capital worth Rs 8. Plus, banks also have to hold an additional buffer of 2.5% of risky assets as Tier 2 capital. Technically Tier 2 capital includes revaluation reserves (the increase in an asset’s value following reappraisal), undisclosed reserves, hybrid instruments and subordinated debt (debt that’s paid only after other debt).

Indian banks are currently not adequately funded according to BASEL III norms.

According to information available currently, on average, India’s banks have around 8% capital adequacy that is 2.5 percentage points short of the mandated norms. Indian banks cannot afford to deviate from internationally mandated norms as they are in business internationally and international banks are in business in India. Now there are two ways to adhere to the capital adequacy norms.

Either they reduce their risky assets by pruning their business to adhere to capital adequacy norms.For this they need to restrict to classical banking operations of operating as a channel for diverting savings to investment use and that too in robust projects. Banks need to do what banks do best – weigh risk against reward. But modern banks are into multiple businesses: housing finance, share broking, merchant banking, forex trading, derivatives trading and a number of related activities.

If this is not possible or desirable, then banks have to find ways to raise their capital. A simple method for that is bail-in law which allows them to raise their capital by writing down a part of their liabilities and converting them into equity.

A simple example will make it clear. Suppose, hypothetically, the balance sheet of a bank is as follows:

Assets

Assets	Liability
Cash & other fixed assets-  5 crores	Deposits – 50 crores
Loans & other long-term investment 50 crores	Repos & other short-term borrowing 20 Crores
Securities & short-term investment 45 crores	Long-term unsecured debt 20 crores
	Equity Capital  10 crores
Total 100 Crores	Total 100 Crores
Capital Adequacy equity capital/ total assets = 10/100*100 = 10 percent

 

Assume that its capital is eliminated due to a large loss (Rs. 10 crores) in its long-term assets. A mandatory recapitalization under a bail-in power would restore the equity position to Rs. 10 crores by converting 50% of unsecured senior debt into equity without the bank having to resort to asset sales.

And post bail-in, the revised balance sheet will look as follows:

Assets	Liability
Cash & other fixed assets-  5 crores	Deposits – 50 crores
Loans & other long-term investment 40 crores	Repos & other short-term borrowing 20 Crores
Securities & short-term investment 45 crores	Long-term unsecured debt 10 crores
	Equity Capital  10 crores
Total 90 Crores	Total 90 Crores
Capital Adequacy equity capital/ total assets = 10/90 *100 = 11.11 percent

Seeing the majority of the current government, international approval and promotion of bail-in laws, it is just possible that the law may be passed with the above bail-in provisions. And momentarily a way out to meet BASEL norms may have been found, problem at hand may be solved but this will damage seriously the financial architecture of the country in the long run.

Now, it is unlikely this development will ever take place, for it would sharply reduce the credibility of banks and the banking systems. Bank losses need to be dealt through robust lending practices, conservative leverage, higher provisioning, continuous stress tests and creation of a bank viability fund based on current working of banks and their profits. In the absence of such measures, the ‘bail in’ clause in the draft FRDI bill 2017 should not become a licence for irresponsible and banking practices.