What is it?
- A clause in the Financial Resolution and Deposit Insurance Bill 2017, introduced in Parliament in August, has created unease. The clause lays the ground for a ‘bail-in’ of failing financial institutions.
- Unlike a bail-out, which constitutes the injection of taxpayers’ funds to shore up finances of a financial institution, a bail-in involves the use of depositors’ funds to do the same. In the proposed Bill, the bail-in clause includes a provision of “cancelling a liability owed by a specified service provider” and “modifying or changing the form of a liability owed by a specified service provider”.
- Bank deposits are a form of liability for the bank as it has to pay interest on them. According to the drafting committee of the Bill, a bail-in can be typically used in cases where it is necessary to continue the services of the ailing financial institution, but the option of selling it is not feasible.
- The Bill proposes to replace the Deposit Insurance and Credit Guarantee Corporation (DICGC), which guarantees deposits up to a value of ₹1 lakh, with a Resolution Corporation which will be empowered to collect the premium that banks pay to the DICGC as an insurance cover for deposits.
- The Bill, however, does not specify the quantum of deposits that will be insured by the new corporation nor the amount of premium it will collect from banks.
- The ₹1 lakh limit has not been updated since 1993; even if one assumes a 5% annual average inflation rate since 1993, the equivalent value of a ₹1 lakh deposit would be well over ₹3 lakh in 2017.
How did it come about?
- The bail-in feature is in line with the best practices adopted around the world. For example, the Financial Stability Board, which has members comprising most G20 countries (including India), has recommended that its members allow the resolution of financial companies using bail-in. Similarly, the European Union has proposed bail-in as a resolution tool.
- The bail-in clause emerged as a possible alternative to bail-outs in the aftermath of the 2008 financial crisis, when numerous banks went bankrupt. So far, the bail-in has been used rarely, the most recent being in Cyprus in 2013, where depositors with over €100,000 in their accounts saw 37.5% of their deposits converted into equity, with another 22.5% held in reserve against a possiblefuture conversion.
- Another 30% were temporarily frozen. In India, the bail-in clause has been introduced as part of a larger comprehensive legislation aimed at the resolution of companies in financial trouble.
Why does it matter?
- The bail-in clause matters because it formalises the risk associated with depositing money in banks. Even now, deposits are not risk-free. In the case of a bank being forced to liquidate, deposits are insured only up to ₹1 lakh; the rest is forfeited.
- This assumes greater importance in the light of the government’s recent efforts to increase banking coverage.
- About 30.7 crore bank accounts have been opened under the Jan Dhan Yojana.
- The banking sector is under stress, with non-performing assets rising to alarming levels, especially for public sector banks. The FRDI Bill is complementary to the Insolvency and Bankruptcy Code brought in last year for resolving bad loans.
- But going by experience so far, banks are expected to face substantial haircuts on this front. The government has promised a ₹2.11 lakh crore recapitalisation plan on its part, with ₹1.35 lakh crore of this coming from bonds.
- It is against this background that the bail-in clause assumes greater significance. Public sector bank deposits remain the preferred parking place for most Indians’ savings.
- Unless the government raises the extent of deposits insured before the bail-in clause kicks in, weaker banks could face a run on their deposits. as smart money will look to move to safer stronger banks or other investment avenues.
- A Joint Committee of Parliament examining the Bill is expected to give its recommendations in the winter session, set to begin on December 15, even as Finance Minister Arun Jaitley has sought to allay concerns over the safety of deposits by hinting at a possible review of the Bill, which could see “corrections” in the drafting process.