Banks caught in strong whirlpool

RBI governor’s concerns for banks & need for Resolution Corporation hints at ‘painful’ reforms on cards
Banks caught in strong whirlpool
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Indian banking sector is caught in a web of unending uncertainty which the outbreak of coronavirus pandemic has unleashed across the globe. The US-based S&P Global Ratings on June 30 came out with an alarming statement on the plight of the Indian banks saying that the coronavirus pandemic may push back the recovery of India's banking sector by years, which could hit credit flows and, ultimately, the economy.

"In our base case, we expect the non-performing loans to shoot up to 13-14 percent of total loans in the fiscal year ending March 31, 2021, compared with an estimated 8.5 percent in the previous fiscal year," said credit analysts at S&P Global Ratings.

Notably, here the banks were still working through a formidable overhang of non-performing assets when the COVID crisis struck. Now, the situation means banks may be saddled with a huge stock of bad loans next year. This 'all-is-not-well' for banks in future has thrown a serious challenge to the financial regulators, especially the Reserve Bank of India (RBI). Despite rolling out various measures to neutralize the impact of COVID tsunami on the financial system of the country, which also includes heavy cut in policy rates, the economy is sliding into depression. Interestingly, COVID – induced recession was already spotted by economic analysts just at the incipient stage of the coronavirus outbreak when governments were analyzing the economic situation as 'pandemic-induced slowdown'.

Now, after two weeks' time when S&P Global Ratings raised red flag on the future health of the banks in India, the RBI governor Shaktikanta Das on July 11 (Saturday) while speaking at the State Bank of India economic conclavedished out his concerns for the Indian banking industry in line with this US-based global rating agency. He said, "The economic impact of the pandemic—due to lockdown and anticipated post-lockdown compression in economic growth—may result in higher non-performing assets and capital erosion of banks. A recapitalization plan for PSBs and private banks has, therefore, become necessary. While the NBFC sector as a whole may still look resilient, the redemption pressure on NBFCs and mutual funds need close monitoring."

He asked banks to identify their weaknesses and strengths in how to deal with the current pandemic and warned such events could be frequent in the coming days and the financial system has to remain prepared.

However, the most fearful part of his speech was call for the setting up of a Resolution Corporation 'to revive failed financial firms'. The apex bank chief pitched for legislative backing to have Resolution Corporation which has to deal with resolution and revival of stressed financial firms.

The proposal for Resolution Corporation was part of the controversial Financial Resolution and Deposit Insurance Bill 2017, which was later withdrawn when protests were intensified against it as anti-bank depositors' act.

Pertinently, for banks and other financial institutions, traditionally the approach has been to merge a failed bank with a larger bank. According to the RBI governor while that definitely protects the depositors' interest, it also tends to pulls down the balance sheet of the larger bank to which the failed bank is merged. A Resolution Corporation is projected as a way to ensure that a bank is resolved rather than liquidated, as depositors are expected to get a much higher value in resolution of the bank as a going concern than in liquidation.

Let's go back to Budget 2020 speech of the Finance Minister NirmalaSitharaman where she among other things disclosed that the Government was working on the contentious Financial Resolution and Deposit Insurance (FRDI) Bill. As stated above, the FRDI Bill, 2017 was tabled in the LokSabha in August 2017, following which it was referred to the joint parliamentary committee. Then the Government was forced to withdraw it on August 7, 2018 following widespread criticism of its controversial provisions, including a "bail-in" clause that suggests depositors' money could be used by failing banks and financial institutions to stay afloat.

Now, let's revisit the contours of the FRDI Bill which I have shared on a couple of occasion in this column, as none other than the regulator is now pitching for need of a ResolutionCorporation, a vital part of the Bill. The Bill exclusively revolves around a situation gripped in financial distress and envisages protection to customers of financial service providers in times of financial distress; and preaches lessons of financial discipline among financial service providers in the event of financial crises, by limiting the use of public money to bail out distressed entities. Among other things, it also aims to strengthen and streamline the framework of deposit insurance, which already stands hiked to Rs. 5 lakh from Rs. 1 lakh.

The Bill also envisages closure of the so far rarely tested "Deposit Insurance and Credit Guarantee Corporation" (DICGC) established in 1961 and replace it by a 'Corporation Insurance Fund'.

What all these 'offers' envisaged in the Bill mean? The Bill is simply loaded with dangers with serious consequences both for financial companies like banks and insurance companies and their customers. As envisaged in the Bill, any financial distress would see amalgamation, merger, liquidation and acquisition of any bank, and any insurance company. As contained in the Bill, even discontinuation of service of employees or transfer of their employment or reduction of their remuneration is also an option to overcome any financial distress of a bank or an insurance company.

As far as setting up a Resolution Corporation. The Resolution Corporation will monitor the health of the financial entities like banks and in case of their failure; will come into play to try and resolve the issues confronting them. The 'Resolution Corporation' once comes into being will have adverse impact on the functioning of the financial regulators. These regulators would be losing teeth as banks, insurance and other financial companies would be left at the mercy of this Corporation, which in turn will be subservient to the Finance Ministry.

In the name of deposit insurance also, the Bill goes against the interest of small depositors through its provision of 'bail-in'. Bail-in' is one under which creditors and depositors absorb some of the losses in case a financial institution fails. In case of a 'bail-in' the depositor rather than a borrower is likely to lose a portion of money deposited in the bank account.

Notably, while exercising 'bail-in' option, the Resolution Corporation will lay hand on liabilities (deposits) of the financial entity to cover the losses and restart its business. More precisely, invoking 'bail-in' option can lead to cancellation of repayment of various kinds of deposits. The deposits in a failed financial entity can also be converted into long term bonds or equity.

The kind of turmoil we have witnessed in our banking system through large magnitude frauds through high profile personalities and the mountain of non-performing assets in the last few years led the Government to work on reintroducing the FRDI Bill. Now the breakdown of economic cycle by the COVID-19 pandemic pushing vital economic sectors into depression has given a readymade stage for the government to push the so-called economic reforms through the FRDI Bill. The statement of the RBI governor about the need to have a Resolution Corporation in place to deal with failed financial entities indicates all this is in pipeline in near future.

However, while going for such reforms wherein reintroduction of the FRDI Bill seems inevitable, the government needs to revisit controversial clauses like 'bail-in' clause to safeguard the interest of public and prevent prudential risks from spilling over into a systematic concern. The depositors should not be forced to absorb losses of a failed financial entity. Otherwise, it would be an act of robbing them of their hard earned money.

(The views are of the author & not the institution he works for)

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