FRDI Bill: An ICU to take care of critically ill patients
Over the past few years, 200 million people in India have opened their first bank account, more than 15 million have purchased their first insurance policy, and more than 1 million have made their first digital financial transaction. As we continue to move towards formalization and inclusion, we must understand if the ecosystem has evolved sufficiently to provide the requisite trust and confidence to the common citizen. A potential new legislation in form of the Financial Resolution and Deposit Insurance (FRDI) Bill would offer concrete steps in helping build consumer trust in the financial sector.
The journey so far has entailed numerous milestones that have contributed to the breadth and depth of the financial sector. Creation of independent regulators, new categories of service providers in banking and insurance, policy changes to encourage inclusion, focus on consumer protection, and a code of conduct are a few such examples. While these are all important advancements, the most important source of trust in a bank is the promise to the depositor to get the full value of her deposit on demand (for a savings account) or in a specified period (in a term deposit). While the endeavour is to have a thriving and ever-growing financial sector, the possibility of failures of a specific institution, and its resulting impact on the system at large, cannot be ruled out.
There are multiple factors that could lead to the viability of a bank or an insurance company to be at risk—lack of capital adequacy or earnings sufficiency, poor asset quality, incapability of management, and non-compliance with applicable laws, to name a few. The global financial crisis in 2008 triggered an unprecedented domino effect resulting in the failure of several financial institutions and banks. Between 2008 and 2014, 507 banks failed in the US. While not to the same extent, India has seen its fair share of bank failures, such as Global Trust Bank, Bank of Rajasthan, and several co-operative banks. While the Reserve Bank of India has assiduously dealt with each failure and ensured that no loss is suffered by the depositors of the failed commercial banks, there is a need to incorporate an explicit and transparent framework to proactively deal with such situations. The banks and other financial institutions are unique with regard to solutions because they accept money from individuals and are deeply inter-connected such that a failure of one could influence other institutions as well.
A few highlights of the Bill, and how these will enhance confidence in the system, are worthy to note:
• First, it provides for the Resolution Corporation to define objective criteria for classification of banks and other financial service providers into five categories of risk, ranging from low to critical. This would ensure that there is a comprehensive mechanism for assessment, monitoring, and dealing with imminent failures before rather than after they occur.
• Second, it fixes accountability and provides authority to act in a time-bound manner to ensure quick resolution. Lengthy resolution processes due to lack of enabling provisions to make decisions would erode customer confidence in the system, result in a run on the banks, and destabilize the sector.
• Third, it provides a better chance for the depositor to recover her money if her bank were to fail. Presently, each depositor is protected up to a limit of Rs1 lakh by the guarantee of the Deposit Insurance and Credit Guarantee Corporation (DICGC). As of 31 March 2017, 92% of deposit accounts were fully protected by this mechanism, as these accounts are with deposits below Rs1 lakh. Uninsured depositors are presently treated on par with claims of unsecured creditors, and rank below preferential payments, which include government claims. The FRDI Bill improves the order of priority for uninsured deposits by placing them above unsecured creditors, government claims, secured creditors for any amount unpaid following the enforcement of security interest; and any remaining debts and dues. The Bill also continues the deposit insurance mechanism.
• Fourth, it provides power to clawback performance incentives paid to senior management of a failed bank. This would ensure that the people responsible for the failure do not benefit from their decisions that led to it.
• Fifth, it provides for a wide range of resolution instruments, such as bail-in, bridge institution, and run-off entity for insurance. These are in addition to the existing tools used such as merger and sale. While sale or merger of the failing entity would be the most preferred mode, it may not always be possible. Neither would the closure of the bank or insurance company be an option as it may be performing a critical function. For example, in run-off, the remaining claims of a failed life insurance company would be serviced through a specially chartered “run-off entity” throughout the duration of the policies. Bail-in is a tool that enables quick restoration of solvency. However, since it entails write down and/or conversion of certain liabilities into equity, there are safeguards included to ensure that it is used in exceptional circumstances. Bail-in can only be used in respect of specific liabilities, which are specified in the regulations framed through a consultative process. These liabilities would be known upfront and well before the bail-in tool is exercised.
Think of the FRDI Bill as putting together an intensive care unit to deal with critically ill patients. The idea is to not let the patient slide into slow death. Instead, the Bill safeguards depositors by protecting the value of the failing bank through speedy diagnosis and a deliberate resolution plan.
Smita Aggarwal is a director at Omidyar Network