A cashier counts Indian banknotes as customers wait in queues inside a bank in Chandigarh in December 2016. Photo: Reuters/Ajay Verma
A cashier counts Indian banknotes as customers wait in queues inside a bank in Chandigarh in December 2016. Photo: Reuters/Ajay Verma

The winter session of the Indian Parliament was delayed because most of the cabinet was campaigning for the Gujarat Assembly elections in Prime Minister Narendra Modi’s home state. Now that the session has commenced, it is expected that there will be fireworks about some contentious provisions in the Financial Resolution and Deposit Insurance (FRDI) Bill.

This 125-page bill was approved by the cabinet in June, and it’s due for debate in this session. It’s part of the multi-pronged effort to resolve India’s gigantic bad-loans problem. These non-performing assets (NPAs) amounted to about US$150 billion by September. More than 90% of all stressed assets are held by the state-owned banks, which disburse about 72% of credit in the country. NPAs amount to more than 75% of the net worth of several state-owned banks.

The central bank’s Financial Stability Report outlines the problem. The gross NPAs of state-owned banks stood at about 8.3 trillion rupees ($128 billion) by June, while the gross NPAs of private banks stood at 1 trillion rupees ($15.5 billion) by September. That’s almost 11% of all bank loans and above 6% of gross domestic product. In addition, there are restructured assets (loans where interest rates and tenures have been rejigged to ease debt servicing) amounting to another $25 billion, which have a high probability of going bad.

The Reserve Bank of India is in the process of conducting a review of bad loans in government banks as of September. Going by the second-quarter results of listed state-owned banks, NPAs have continued to rise, albeit at a slower pace.

The Insolvency and Bankruptcy Code (IBC) created a fast-track resolution system: Creditors can go to the National Company Law Tribunal (NCLT), take over companies promoted by defaulting debtors and auction them off, to recover dues, within a set time frame. Side by side, a massive bank-recapitalization plan envisages shoring up the net worth of government-controlled banks by more than 2.1 trillion rupees, through a complicated process involving equity sales and the issue of recapitalization bonds.

The FRDI is another step in this process. The bill envisages setting up a Resolution Corporation to monitor banks and insurance companies, and in cases of failure, to resolve these cases. So far, so good.

The most contentious clause in this proposed legislation is No 52. It states that “… the Corporation may, in consultation with the appropriate regulator, if it is satisfied that it necessary to bail-in a specified service provider to absorb the losses incurred, or reasonably expected to be incurred, by the specified service provider and to provide a measure of capital so as to enable it to carry on business for a reasonable period and maintain market confidence, take an action under this section by a bail-in instrument, or a scheme to be made under Section 48.”

In extreme circumstances, can banks refuse to pay interest, or restructure the terms and tenures of deposits, or simply refuse to let depositors withdraw funds? This has happened in other bail-ins

This is the first time the term “bail-in” has been used in India. It is shorthand for allowing a bank to restructure its liabilities. Subsections of the clause state that bail-ins could include canceling liabilities owed, and modifying and changing the nature of liabilities owed. Depositors’ funds are liabilities, and so are any bonds issued by banks.

In extreme circumstances, can banks refuse to pay interest, or restructure the terms and tenures of deposits, or simply refuse to let depositors withdraw funds? This has happened in other bail-ins.

Cyprus was forced to use such a system in 2013. There was a long enforced bank holiday after which bankrupt banks in essence issued IOUs when depositors tried to withdraw their own money. In the end, depositors recovered only about 50% of their dues. Other nations including the US, Canada, New Zealand, the UK and Germany also have bail-in provisions in respective legislations. But it should be noted that those places also have social security and highly educated depositors.

Deposit insurance in India just offers protection to a limit of 100,000 rupees per account – or about $1,550. This is an old limit set in 1993 when that amount was worth about $3,450. It should ideally have been updated and indexed to 24 years of inflation.

The FRDI doesn’t change that limit but it allows for explicit changes of terms and tenure on amounts beyond that limit. For example, an ailing bank might convert deposits into financial assets such as equity, for instance. However, the value of such assets would be moot in the case of a failed bank and depositors may not wish to convert their cash in this fashion.

Another clause, No 55, says that “… no creditor of the specified service provider is left in a worse position as a result of application of any method of resolution, than such creditor would have been in the event of its liquidation.” Again, this doesn’t offer much comfort, since a bank liquidation would probably mean that depositors received no more than the 100,000 rupees that’s insured.

Understandably, the FRDI Bill has met with divided political opinions and caused a certain amount of panic among ordinary depositors. The government has made assurances that there is no danger  to depositors. It is true that the bill doesn’t put any more money at risk than the extant provisions of deposit insurance. It also creates a specialized resolution mechanism for financial institutions. It would also be politically daunting for the government to use this clause.

Unfortunately, there is a lack of faith in the banking system and in such assurances after the shock of demonetization, when depositors were made to jump through hoops for their own money. It is also true that, if such a provision exists, sooner or later, some government or another will be tempted to use it.

In the Indian context, where the banks at risk are state-owned and the major defaulters are crony capitalists who received loans thanks to links to the bureaucrat-politician nexus, this seems like a bad idea. There are already plenty of moral hazards embedded in the system.

The assumption is that government has to bail out the banks it owns every so often. This has happened multiple times. If the burden of rescue is shifted to depositors, even in theory, it will encourage more attempts to milk the system on one hand; on the other hand, it will foster even greater distrust of the formal banking system among depositors.

Devangshu Datta is a journalist and columnist. He writes about investment, economics, science and technology and the intersections between them.