Are you ready to take a significant cut on your deposits with Bank ?

The recent fall of PMC Bank and the mighty YES Bank has sent shivers across the spine of many Deposit Holders of the bank. The depositors have started staring at their deposits in the entire banking system with suspicion. They are facing the prospects of “BAIL-IN”  which,  in extreme conditions can wipe out their money lying in the Banks.

The bail-in action 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 Rs.5 lakh; the rest is forfeited. This assumes greater importance in the light of the government’s recent efforts to increase banking coverage. About 30.70 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.

What is Bail-In

A bail-in is the opposite of a bailout, which involves the rescue of a financial institution by external parties, typically governments, using taxpayers’ money for funding. Bailouts help to keep creditors from losses while bail-ins mandate creditors to take losses.

 A bail-in provides relief to a financial institution on the brink of failure by requiring the cancellation of debts owed to creditors and depositors. Bail-ins and bailouts are both resolution schemes used in distressed situations. Bailouts help to keep creditors from losses while bail-ins mandate creditors take losses.

Under Bail-ins the banks will be allowed to use depositors money as per their wish. As it is, public do not get adequate interest. Now the banks want to use public money for resolution of bad debts. As a depositor, the public is  squeezed from both sides.

Investors and deposit-holders in a troubled financial institution will be forced to keep the organization solvent rather than face the alternative of losing the full value of their investments or deposits in a crisis. Governments also would prefer not to let a financial institution fail because large-scale bankruptcy could increase the likelihood of systemic problems for the market. These risks are why bailouts were used in the 2008 Financial Crisis and the concept of ‘too big to fail’ led to widespread reform.

Bail-in schemes are being more broadly considered across the globe as a first phase resolution to help mitigate the number of taxpayers’ funds used in supporting distressed entities. Bailouts were a powerful tool in the 2008 Financial Crisis, but bail-ins have their place as well.

The Finance Minister late Mr. Arun Jaitley had introduced a Bill called the Financial Resolution and Deposit Insurance Bill, 2017 (FRDI Bill), in the Lok Sabha on 10 August 2017 for dealing with bad loans which had touched over Rs10 lakh crore. He had announced the largest ever bailout (recapitalisation) of public sector banks (PSBs) of Rs 2.11 lakh crore in October 2017. It had triggered panic among depositors over the controversial ‘bail-in provision’ which held out the threat of forcibly converting term deposits with banks (above DICGC guaranteed limit of Rs. 1 Lakh per depositor) into equity to recapitalise failed banks. The Bill contained a clause called “Bill-In” according to which Depositors of a failing financial institution would bear a part of the cost of resolution by reduction in their claims. There was a blind panic amongst the public and many depositors had started withdrawing their deposits from the bank fearing a hair-cut on their amount of deposit to stabilize the failing bank or financial institution.

FRDI Bill  had a bail-in clause that allowed deposits to be turned in to equity to deal with massive bad debts. This meant that people’s small savings were not safe even in public sector banks. All this reflected the sad state of affairs of the manner in which public sector banks were being misused.

A campaign & critique against the Bill saw trade unions, people’s movements, civil society organisations and concerned citizens raising their voices collectively. They held public meetings, engaged with Parliamentarians and Joint Parliamentary Committee, and compelling them to relook at the Bill.

Finally, the Bill was withdrawn in August 2018.

However, it was clear right then that the government would  repackage and reintroduce the Bill again.

The government has its hands tied up by its commitments to the Financial Stability Board (FSB) of which India is a member. Post 2008, after the global economic meltdown, FSB recommended that in a future financial collapse the governments would not end up bailing out such financial institutions, as done in the US then, incorporating new resolution instruments like bail-in and bridge institutions.

India is under the pressure emanating from the Group of 20 (G20) and the Financial Stability Board (FSB), which have been setting the financial regulatory reform agenda since the global financial crisis. The ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’ was adopted by the FSB in October 2011, which was subsequently endorsed by the G20 heads of states at the Cannes Summit (in November 2011) as the ‘New International Standards for Resolution Regimes.’

According to the Financial Stability Board Report (October 2019) on Implementation and Effects of the G20 Financial Regulatory Reforms countries like France, Germany, Hong Kong, Italy, Netherlands, Spain, Switzerland, United Kingdom, and the United States have implemented all the resolution tools, while Canada has done all except powers to insurers and Japan, except the bail-in clause. Countries such as Argentina, Australia, Brazil, China, Indonesia, Korea, Mexico, Russia, Saudi Arabia, Singapore, South Africa, and Turkey have only partially implemented the reforms recommended by FSB, with none of them implementing the bail-in provision.

The revised Financial Sector Development and Regulation (Resolution) Bill, (FSDR)

The financial sector resolution framework covers a wide spectrum of financial entities including banks, insurance companies, financial market infrastructure, payment systems and other financial service-providers which are now scattered under different legislations. For the first time, it also covers cooperative banks and regional rural banks.

India and a few other countries have yet to put in place ‘an effective resolution regime’. The new Bill expects to provide certain ‘critical powers’ for resolving banks, such as “power to terminate contracts, write down debt, modify liabilities or set up bridge institutions,” as well as a framework for resolving ‘cross-border’ (foreign) banks.

The Bill will also provide clearly defined triggers for prompt corrective action (PCA) framework to bring a problem institution into resolution. It covers parent institutions as well as subsidiaries (a lesson learnt from Infrastructure Leasing & Financial Services—IL&FS—which was allowed to spawn over 347 subsidiaries and associates while the group holding company remained unlisted and out of the public eye).

The new FSDR Bill aims  to cover a ‘systemic vacuum’ with regard to bankruptcy situations and will include the resolution of large non-banking finance institutions. The Bill takes into account situations arising out of giant institutions that failed, such as IL&FS and Dewan Housing Finance Ltd (DHFL), HDIL, PMC Bank and now YES Bank

The Bill aims to handle financial sector failures without transferring the burden to taxpayers by establishing a transparent mechanism to deal with such failures.

The FSDR has removed the controversial ‘bail-in’ provision without eliminating the worries attached to it. It proposes that the Resolution Authority (RA) is empowered to cancel or modify liabilities, subject to safeguards. RA will also decide the extent of increase and will also have the power to modify the deposit insurance limit.

The RA, along with sector regulators, will classify all service-providers into five categories, namely, low, moderate, material, imminent and critical. The classification will take into account several features of the specified service-providers, including adequacy of capital, asset quality, leverage ratio, liquidity and capability of management.

Tools of Resolution: These include the use of one or more of the following:

1) Transferring the whole or part of the assets and liabilities to another entity;

2) Creating a bridge service-provider;

3) Cancellation /modification of liabilities;

4) Merger or amalgamation;

5) Acquisition;

6) Liquidation;

7) Run-off, in case of an insurance company, if deemed appropriate.

It was the need of the hour to take  correct assessment post-1991, after India’s economic liberalisation led to the entry of new private banks, private insurance companies, the setting up of massive non-banking finance companies as well as private sector-professionally managed stock exchanges and depositories.

Since then, there have been only two or three force-mergers, while the successful private sector banks, such as HDFC Bank, Kotak Bank and ICICI Bank, have acquired smaller banks, or they have been transformed after a change in management (RBL Bank). State Bank of India has now jumped in to save YES Bank

Bail-Ins across the Globe

Cyprus and European Union resolutions provide two examples of bail-ins in action.

The Cyprus Experiment

While the general public became familiar with the subject of bailouts in the aftermath of the Great Recession of 2008, bail-ins attracted attention in 2013 after government officials resorted to the strategy in Cyprus. The consequences were that uninsured depositors in the Bank of Cyprus lost a substantial portion of their deposits. In return, the depositors received bank stock. However, the value of these stocks did not equate to most depositors’ losses.

European Union

In the European Union, a new resolution framework is being considered that would potentially incorporate both bail-ins and bailouts. Bail-ins would be involved in the first phase of a resolution, requiring a specified amount of funds to be written off before bailout funds would become available.

Bail-Ins Versus Bail-Outs

Bail-outs occur when outside investors, such as a government, rescue a borrower by injecting money to help make debt payments. For example, U.S. taxpayers provided capital to many major U.S. banks during the 2008 economic crisis in order to help them meet their debt payments and remain in business, as opposed to being liquidated to creditors. This helped save the companies from bankruptcy, with taxpayers assuming the risks associated with their inability to repay the loans.

A bail-in occurs when the borrower’s creditors are forced to bear some of the burden by having a portion of their debt written off. For example, bondholders in Cyprus banks and depositors with more than 100,000 euros in their accounts were forced to write-off a portion of their holdings. This approach eliminates some of the risk for taxpayers by forcing other creditors to share in the pain and suffering.

While both bail-ins and bail-outs are designed to keep the borrowing institution afloat, they take two very different approaches to accomplishing this goal. Bail-outs are designed to keep creditors happy and interest rates low, while bail-ins are ideal in situations where bail-outs are politically difficult or impossible, and creditors aren’t keen on the idea of a liquidation event. The new approach became especially popular during the European Sovereign Debt crisis.

Using Bail-Ins to Save Institutions

Most regulators had thought that there were only two options for troubled institutions in 2008: taxpayer bailouts or a systemic collapse of the banking system. But, bail-ins soon became an attractive third option to recapitalize troubled institutions from within, by having creditors agree to rollover their short-term claims or engage in a restructuring. The result is a stronger financial institution that isn’t indebted to governments or external influencers — only its own creditors.

In these scenarios, the companies were able to reduce the payments to creditors in exchange for equity in the reorganized company, effectively enabling the lenders to save some of their investment and the companies to stay afloat. The airlines would then benefit from the reduced debt load and their equities – including that issued to debt holders – would increase in value.

Interestingly, bail-ins can complement bail-outs in some cases. Successfully bailing-in some creditors gets rid of some financial strain, while securing additional financing from others helps the situation by reassuring the market that the entity will remain solvent. But, the risk is always that the bail-in of some creditors will discourage others from getting involved, since they’d need to take on the same reforms. This makes bail-ins less common during systemic crises involving many financial institutions.

The Future of Bail-ins

The risk, of course, is that the bond markets will react negatively. Bail-ins becoming more popular could increase risks for bondholders and therefore increase the yield that they demand to lend money to these institutions. These higher interest rates could hurt equities and end up costing more over the long-term than a one-time recapitalization by making future capital much more expensive.

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.

Why does bail-in clause matters?

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 Rs. 5 lakh; the rest is forfeited. This assumes greater importance in the light of the government’s recent efforts to increase banking coverage. About 30.70 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 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 Rs. 2.11 lakh crore recapitalisation plan on its part, with Rs.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.

What next?

A viral message going around on WhatsApp, apparently written by a Mumbai-based chartered accountant, titled “This tsunami will wipe out your money lying in the banks”

“If this bill is passed then the banks will be allowed to use depositors money as per their wish. As it is, we do not get adequate interest. Now they want to use our money for resolution of bad debts. As a depositor, we are squeezed from both sides.

The bail-in clause in the new bill that will give more teeth to the banks and regulators to use public deposits to make good the losses suffered by way of loans that are never recovered from big borrowers.

But first, let us understand what are the provisions today when a bank goes bust?

In 70-years of independent India history, no public sector bank has gone bust. There are cases of several co-operative banks and private sector banks that have shut down, but the Reserve Bank of India has stepped-in to merge banks on the verge of a collapse with bigger banks. In 2014, public sector bank Canara Bank took over the assets of Amanath Co-operative Bank Ltd, Karnataka’s first scheduled urban co-operative bank. While deposits up to Rs 1 lakh were protected under the insurance scheme, any deposits above that had to take a 18% haircut.

In 2004, Global Trust Bank went bust following high exposure to the stock market in the 2001 Ketan Parekh scam. In a bid to save one million depositors, the Reserve Bank of India stepped in and forced the bank to merge with Oriental Bank of Commerce. While the shareholders took a hit as no share swap deal was provided for, the depositors were protected by the merger.

Also in 2004, Mumbai-based South Indian co-operative bank shut down following nexus between bank employees and politicians resulting in issuance of loans that could never be recovered. The country’s biggest co-operative bank, Saraswat Bank finally took over in 2008 and it was widely reported that depositors would have to forego some part of their unsecured deposits.

One depositor had multiple deposits worth Rs 10 lakhs in the bank told that all they got was Rs 3 lakhs (Rs 1 lakh insured amount for each account) under the deposit insurance scheme. The rest of the unsecured deposits never came back even after Saraswat took over the bank in 2008.

So, why FRDI Bill?

Contrary to popular perception, the FRDI Bill is not an invention of the Narendra Modi government. India is part of the Group of 20 economies group that have endorsed the Financial Stability Board’s proposal called “Key Attributes of Effective Resolution Regimes for Financial Institutions”. This proposal has a provision for a “bail-in” to ensure that a country’s economy is not destabilised in the event of a big default by a large bank(s).

The Financial Stability Board was set up in 2009 post the global financial crisis in 2008 when US had to bail out big banks with taxpayer money to prevent a large scale systemic collapse. The learnings from this catastrophic event for central bankers was to never reach a similar situation where governments have to dip into taxpayers money to bail out banks or allow any institution to become ‘too big to fail’.

But what about depositors? What has changed for them?

Given below is the text of the preamble taken from the Financial Stability Board’s website.

The objective of an effective resolution regime is to make feasible the resolution of financial institutions without severe systemic disruption and without exposing taxpayers to loss, while protecting vital economic functions through mechanisms which make it possible for shareholders and unsecured and uninsured creditors to absorb losses in a manner that respects the hierarchy of claims in liquidation.“

To make it clear, from a depositor’s point of view, the risk profile has not changed substantially. Post the notification of the Act, a bail-in clause will not apply to the deposits covered by insurance the upper limit of which has been increased from Rs. 1 Lakh to Rs. 5 Lakhs.

Considering that the depositors are looking at the bail-in clause with suspicion, the finance ministry has also clarified that the legal provisions in the bill will ensure that the rights of the depositors are considered at an elevated level over unsecured creditors and dues owed to the government.

While it is too early to give a clean-chit to the bail-in provisions, banking experts argue that it will be politically suicidal for any government to hurt the interests of depositors, unless in extreme cases where the country’s economic ecosystem is on the verge of a collapse.

Out of these five categories, the threat to a depositor’s unsecured deposits only comes in when a institution is categorised as critical. The corporation will undertake its resolution by using options which include: (i) transfer of its assets and liabilities to another person, (ii) merger or acquisition, and (iii) liquidation, among others.

Key concerns

Despite the entry of several private banks in the country in the last 25 years, a public sector bank is still seen as a very safe avenue to park your deposits. This is one reason why depositors, especially senior citizens park their savings in public sector banks despite a low interest regime in recent years and better avenues of investment like mutual funds.

But a bail-in option implicitly holds a depositor who provides low-cost capital to the bank to lend to others, responsible for the losses of the bank along with other unsecured creditors. Also the failure of the bill to quantify the deposits that will come under the insurance scheme has also led to worries among depositors if their interests will actually be protected.

The government recently provided Rs 2 lakh crore by way of recapitalisation of PSU banks. Total bad loans of the country’s 38 listed commercial banks have touched the Rs 12.50 lakh crore figure. This amounts to over 12% of the total loans given by the banking industry.

But here is the catch. Public sector banks have over 90% of these non-performing assets on their books. The government has already made its intention clear to consolidate loss making banks with bigger banks in order to improve the financial health of these entities.

Unless these moves are matched by a tight rap on the knuckles of willful defaulters and accountability of bankers who manage the disbursal of loans made under questionable circumstances, the bail-in clause will always be looked at with suspicion as a case of “robbing Peter to pay Paul

Sources: Information available in the public domain

This write up is meant only for academic purposes and not to instill fear amongst the bank depositors. Rather it is an attempt to make the public aware of the likely consequences of bail-in provisions that may sooner or later become a  law. The depositor holders may accordingly redesign their bank deposits just in case a bail-in occurs for any financial institution.

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May 2021