Photo: Mint
Photo: Mint

Opinion | Let clear principles prevail in the bailout of Yes Bank

Resolving bank failure is tough but following a set of principles could achieve a fair and efficient outcome

Resolving Yes Bank’s failure is no easy task. Some bondholders are already challenging the restructuring plan of the Reserve Bank of India in court, and seem ready for a long-drawn battle. How much dilution is fair for existing shareholders to take? Should the value of the Additional Tier 1 (AT-1) bonds be written off entirely? As such issues become matters of policy discussion and addressal, we must not lose sight of some fundamental principles of resolving bank failures. Three of them should be on the top of the list: honour contracts, address market failure and protect systemic stability.

Honouring contracts is vital for achieving efficient outcomes between contracting parties such as lenders and borrowers, managers and shareholders, and insiders and outsiders. If there is uncertainty over this fundamental principle, contracting parties will shy away from entering contracts in the first place. Lenders will be less willing to lend. Prospective minority shareholders will be less keen to buy shares in a company. This will ultimately compromise the economy’s allocative efficiency, or the market’s ability to deploy capital to its best use.

There are several issues in the application of this principle in Yes Bank’s resolution. The most visible one concerns the decision of writing off its perpetual contingent, or AT-1, bonds. According to the original agreement, these additional tier-1 (AT-1) bonds are indeed supposed to be written off at a time like this. And this write-off need not happen before the common equity value goes down to zero. The entire idea behind these perpetual contingent bonds is to improve a bank’s capitalization if its common equity value falls below a certain threshold, but does not hit zero.

These bondholders and some commentators are arguing that writing off those bonds will be a big blow to India’s bond market. This is just the opposite of the truth. Not writing them off in accordance with the original contract will create a severe moral hazard problem. What incentive would any bondholder have to correctly price and monitor these banks in the future? Market discipline would die a quick death, and the bond market will suffer in the long run.

Therefore, the resolution process should honour the contract and write off the entire value of Yes Bank’s AT-1 bonds.

The second core principle in this resolution should be to tackle some critical market failures that led here. Several observers have pointed out the failure of board oversight, promoter negligence and reckless lending at the bank. Indeed, these issues must be addressed. But there seems to be another vital market failure hidden in this crisis: the purchase of AT-1 bonds by retail investors.

AT-1 bonds are “information-sensitive" instruments, which means that the value of these instruments is extremely sensitive to information on the firm’s fundamentals. Also, they are very complex financial securities. Understanding the risk and reward associated with these securities and valuing them properly is not an easy task even for the best of market professionals. Retail investors are certainly not suited to buy this product. Still, several of them ended up holding Yes Bank AT-1 bonds in their asset portfolios.

Banking theory relies on the idea that demand deposits are information-insensitive instruments. Hence, a retail investor can place deposits in a bank without worrying about understanding the real risks borne by it. Government-backed deposit insurance makes deposits even more liquid and riskless. Hence, retail investors should hold regular deposits in a bank, and not complex securities like AT-1 bonds. If such bonds are sold to them without proper disclosure of the associated risks, then it amounts to a serious market failure. And, this must be corrected. Holding investment advisors to higher standards of fiduciary responsibility is one way of doing so. Prohibiting retail investors from investing in such securities is another critical step to prevent such a market failure.

Meanwhile, the resolution process could consider a partial or full restitution of value to retail investors in Yes Bank’s AT-1 bonds, if these products were indeed mis-sold to them. But such a rescue must not extend to large professional investors who willingly bought these bonds for higher returns. One mechanism to do this could be to create a separate fund for retail investors with investments capped at a certain point. Or, their AT-1 investments up to a specific limit could be converted into a simple deposit contract. The legal hurdles may be insurmountable. However, in principle, those who mis-sold these products to retail investors should be required to compensate them.

Sometimes, these principles can come into direct conflict with each other. If the resolution allows retail investors in those AT-1 bonds to recover their investments, it would go against the “honour the contract" principle, but it would address the “market failure" issue. How should we reconcile this conflict? That’s where the third principle comes in: ensuring systemic stability. After all, the regulator’s main objective is to restore the market’s faith in the country’s financial system. While this is not an easy task, protecting the capital and confidence of small investors can go a long way in restoring their faith in the banking system.

Resolving bank distress is never an easy job. But honouring contracts, addressing market failure and ensuring systemic stability can together go a long way in achieving a fair and efficient outcome.

Amiyatosh Purnanandam is Michael Stark Professor of Finance, Ross School of Business, University of Michigan

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