Till very recently, the Indian government used to bail out banks as and when they had huge losses. Under the Financial Resolution and Deposit Insurance (FRDI) Bill, 2017, the Centre now seeks to bail-in depositors’ money as well in a difficult situation. The public response to this has been very negative. But what is the alternative?
As per the proposed legislation, as and when a financial institution needs to be liquidated, proceeds from the sale of assets will be distributed in the following priority order: insured depositors, resolution costs, workmen dues and secured creditors,wages to employees, uninsured depositors, unsecured creditors, government dues and remaining secured creditors, remaining debt and dues, and shareholders.
The repayment to uninsured depositors (at number 5) is somewhere in the middle of the seniority of claims on banks wherein insured depositors are the senior most claimants (at number 1) and shareholders are the junior most claimants (at number 9). So, there is indeed a risk for uninsured depositors. This is the main concern expressed by depositors (as deposit insurance has so far been for deposits up to Rs 1 lakh only). Before we come to what needs to be done, let us understand the problem.
It is widely acknowledged that in asset markets, there is considerable risk and ‘noise’. So, there is need for investors to be very well-informed; this is not always easy or even desirable.
This is where banks are useful. Unlike instruments in financial markets, bank deposits are information-insensitive products. This means that the depositors go to banks because they are not well-informed and finance-savvy in the first place. So, it is very reasonable to expect safety there. That is also why they accept low returns compared to those on other assets. This is particularly true in a country like India where the real interest rate on bank deposits is often negative.
Furthermore, the bulk of depositors are small and scattered. They cannot monitor or negotiate with banks on returns on their depositors including in times when banks face trouble. In this context, the government is supposed to act as the representative of depositors in safeguarding their interests. This is, in fact, an important rationale for prudential regulation of banks.
In this background, it is rather unreasonable that bank depositors should be expected to bail-in a bank as and when it is in trouble, as is required of them under the proposed bill.
However, the view of Indian government appears to be that it has been coming to the rescue of banks (and their depositors) for very long, and there is a need for a change in this policy. The financial burden on the Centre is, in final analysis, a burden on the taxpayer (and on the poor who may have received the benefits if the funds were not used for bail-outs). This burden has been huge in the past, and this cannot continue. This government view too appears reasonable.
How do we reconcile these two views and come to a middle ground that addresses the concerns of a common person in her capacity as a taxpayer (or recipient of subsidies) and as a depositor?
Broadly speaking, a bank gets funds from two sources: shareholders (and other such stakeholders like investors in subordinated debt) and depositors. The bulk of the funds come from depositors. The shareholders (and other such stakeholders) have relatively little stake in banks. It is true that under Basel capital adequacy norms, banks are required to maintain some minimum capital. However, this is where we have a serious deficiency.
It is widely believed that the Basel capital adequacy norms are very reasonable, given the efforts put in by experts in arriving at such norms. However, it is not well-known that serious reservations had been expressed about such ‘adequacy’ norms long before the Global Financial Crisis and the Great Recession happened in the US and elsewhere. It is true that now we have Basel III norms and the regulations have been relatively tightened but that need not be the last word. The Centre can always go beyond the (minimum) norms suggested by the Basel Committee.
It appears that the Indian government is interested in including an element of a market solution to the problem of possible large losses in banks. There is nothing in this argument except that the market solution need not lie in the baling-in of depositor money.
Instead, it can lie in having seriously adequate capital in banks. It is often argued that equity and such other capital is costly and/or unavailable even in normal times. However, this argument has been seriously refuted. So, the way forward is to press for more bank capital.
Adequate capital in any bank can include contingent capital that is agreed to ex-ante but is provided ex-post as and when and if the need arises. It is true that the market for contingent capital is not well developed and so such capital is not usually available. But that is where the Centre needs to step in and provide capital that is usually not available. The government has not done this so far. It has instead provided the usual (non-contingent) capital that is available anyway in financial markets. There is a need for rethinking here. The literature on banking crises includes other policy suggestions that can make banking meaningfully stable.
It is often argued that it is a fact of life that banks do get into trouble now and then. This line of argument comes with the implicit suggestion that bail-outs or bail-ins are inevitable. Again, this is not true. Countries like Canada have had stable and efficient banking with hardly any bail-outs or bail-ins. It is true that there are few such countries in the world but that is because the legal, institutional and regulatory framework for banks has been faulty in one way or another in many parts of the world. So, there is a deeper issue here. It is worthwhile examining this now that a major legislation on banking and finance is under consideration in India.
It is true that in some other countries like Greece and Cyprus, the bail-in of depositors’ money has been invoked. However, this does not make it a correct policy. Also, the idea of a bail-in is often in the context of large wholesale deposits on which a risk premium is paid but that is not the situation in India.
Gurbachan Singh is Visiting Faculty, Indian Statistical Institute (Delhi Centre) and Ashoka University.