After months of widespread protest by politicians and media commentators, the government has decided to withdraw its somewhat infamous Financial Resolution and Deposit Insurance (FRDI) Bill which would have brought in the provision of “bail in” for the financial sector.
Under it, a framework had been laid down for the resolution of stressed financial sector firms (this was needed) but there was also a provision for bank depositors being treated the same way as creditors. Depositors would have to take a ‘hair cut’, like shareholders and creditors, through the resolution process.
The government initially sought to reassure without being specific on worries over the “bail in” provision. But it has now acted as pre-election pressure has built up. This indicates that the move is tactical and there is no change of heart or evidence of having become wiser.
It is, therefore, necessary to go back to the basics, spell out again why the move was all wrong so that it will be difficult to revive the proposal at some future date if changes in electoral arithmetic allows for it.
This is because governments under fiscal pressure will always try to minimise their “bail out” (recapitalisation) bill and will be tempted to get others, including depositors, to share the burden. The intellectual justification for this will be the fact that “bail in” is a part of the resolution mechanism the world came up with post-2008 financial crisis and has been blessed by the Reserve Bank of India.
Shareholders and creditors having to take a haircut in any general firm under the resolution process is par for the course. But things get tricky when it comes to financial sector firms and particularly systemically important ones like those which are very large (too big to fail), like public sector banks in India. The financial sector is different because it survives on trust and in it contagion and panic spread fast and create a domino effect.
Fear of a crisis in one firm can create panic, which tends to spread fast from one firm to another. And panic will be created if hundreds of thousands of depositors of a large bank find one fine morning that they are in danger of losing a part of their deposits. This will make them queue up before their bank to take out their deposits and thus create a run on the bank. A run on one bank can easily lead to a run on other banks as panic spreads. So “bail in” should not include bank depositors as that can lead to financial panic.
Earlier this year, currency shortage in some parts of the country led to minor panic with depositors queuing up before banks to take their money out. Confidence in the system had already been partly undermined by demonetisation, which also created massive queues before banks of customers seeking to deposit banned notes as also to take out minimum cash needed to run their affairs.
There should, in fact, be carefully thought out incentives to encourage people to not hold their savings in cash but to keep them in bank accounts. Reaching banking facilities to every corner of the country and facilitating digital banking should go along with incentives to promote bank deposits. This will reduce the extend of cash holding which became clear when demonetization was undertaken.
Historically, bank deposits became significant after bank nationalisation which sought to take banking to the masses with rapid branch expansion. Facilitated by this the country’s savings rate rose sharply and enabled public investment. This, in turn, made it possible for rapid economic expansion to take place when policy impediments to growth were removed through liberalisation in the nineties. Today, as the burden of bad loans raises questions over public sector banks’ ability to lend profitably, the single function which they can still render and make themselves useful is attracting deposits.
One concrete step which can be taken immediately is to raise the level of deposit insurance which was last fixed at Rs 1 lakh in 1993. Since then India’s nominal GDP has gone up by over 20 times. By that token the deposit insurance ceiling should be fixed at Rs 20 lakh. This change will not involve any additional government expenditure other than hiking of premium payable by banks to the Deposit Insurance and Credit Guarantee Corporation, a Reserve Bank of India subsidiary. At the end of the day, in the case of public sector banks, it will come back to the government as part of the dividend paid by RBI to the government.
As no commercial bank has been allowed to fail (troubled banks have been merged), not to speak of large public sector banks, chances of actual claims having to be paid out under deposit insurance are likely to be zero. Against this, the government will gain enormously in terms of the restored and renewed confidence of bank depositors. This will greatly improve financial stability which was in fact the aim behind introducing the bill that has now been withdrawn.
Along with this, enormous strides still need to be taken to reach the banking infrastructure, physical and digital, to all corners of the country. Villagers sometimes still need to walk miles to get to a bank ATM, not to speak of a branch. Plus, those who are totally uninitiated, many of them illiterate, will have to be hand held in order to be able to use banking services. In this regard, microfinance institutions have taken forward financial inclusion by hand holding many of the previously excluded to points where bank branches had not reached.
As people feel totally safe about keeping their money in banks and more and more can easily access minimum financial services, the formalisation of the economy will go forward, increasing both financial stability and growth prospects.
Including bank deposits within the ambit of “bail in” was an attempt to put into effect something that is theoretically unexceptionable and accepted by developed economies without taking into account India’s real life complexities and historical experience.
Subir Roy is a senior journalist and the author of Made in India: A study of emerging competitiveness (Tata Mcgraw Hill, 2005) and the forthcoming Ujjivan: The microfinance frontrunner (OUP).