Classroom Archives - Page 22 of 58

The Parliament is considering the Financial Resolution and Deposit Insurance Bill (FRDI), 2017 to give a guideline for resolving crisis in financial institutions and as well as to protect the depositor’s interest. Objective of the Bill is to create a comprehensive resolution framework for specified financial institutions in the country. The Bill if passed will create an insolvency regime for financial sector entities. What is the resolution regime from the angle of financial institutions? Resolution regime is a government created legal framework that resolves a failed bank/financial institution in an orderly way, so the financial markets do not collapse. Simply, it is an insolvency regime for financial institutions. “Resolution” indicates an orderly resolution of distressed financial firms without taxpayer’s support. The resolution regime provides mechanisms and guidelines for an orderly management of the distressed bank’s affairs either by reconstructing it or by liquidating it- but without using public money. A proper understanding of the relevance of the Bill need knowing the background in which the Bill was created. Background of the Bill Specifically, the Bill is an after effect of the 2007 global financial crisis after which several countries have introduced resolution regimes (laws) to manage crisis in financial institutions. The adverse effects of failure of banks were felt during the financial crisis of 2007. Banks were rescued using tax payers’ money. Most of these banks were failed due to excessive risk taking. Questions were raised from the public about the practice of rescuing failed banks using tax payers’ money. Since then, regulators or central banks and governments are designing ways to rescue financial entities without using public money and at the same time avoiding the failure of such entities. The resolution regime is a child of the financial crisis of 2007 and it helps the economy to settle a failed bank without using money of the public and at the same time by avoiding any systemic trouble. In Europe and in the US, banks have to prepare a plan for their restructuring or make the winding up process if they face crisis. Here, in the case of FRDI Bill, the purpose is to create a resolution regime for financial institutions when they face crisis without creating burden for the tax payers. The FRDI Bill contains two related components: (i) resolution (of financial entities) and (ii)deposit insurance (of the depositors with the financial entities). The Deposit Insurance Corporation was established in 1962 to given protection to depositors. As per the current norm all deposits with banks worth Rs 1 lakh and below gets insurance and will be protected in the case of the failure of the bank. Though several banks were failed, and depositors lost money; after 1969, no depositor has lost his money despite failure of few banks. This is because the government has merged failed banks with other banks especially PSBs. Similarly, the RBI strengthened its supervision to track and control any weaknesses in the banking system. If any notable weaknesses appear in any bank, the RBI initiates several counter measures like banning of lending by the bank, moratorium mergers. The present Prompt Corrective Action Plan is also a good guideline for the RBI to undertake measures in a pre-emptive manner. Resolution provisions of the FRDI Bill One of the core area of the FRDI bill is how to manage/resolve financial sector distress or to manage crisis in a financial entity. Here, the Bill provides the creation of a Resolution Corporation to manage a critical risk entity. The RC and the regulators should identify the level of risk faced by a financial entity. Here financial entities will be classified under five categories based on their risk of failure by either the Resolution Corporation or the regulator (i.e., the RBI for banks, IRDA for insurance companies, and SEBI for stock exchanges): (i) low, (ii) moderate, (iii) material, (iv) imminent, and (v) critical. A financial institution is referred to the Resolution Corporation Institutions are covered under the proposed resolution regime As per the Bill, the resolution regime will be applicable for banks, insurance companies and specified financial sector entities. Resolution Corporation The central organisation under the FRDI mechanism is the Resolution Corporation. As per the Bill, a Resolution Corporation will be formed to look after several functions including: Providing Deposit insurance Assigning risks to viability of a covered service provider (financial entity like a bank) Inspection of the service provider Resolution of a service provider Act as a liquidator Any other functions designated to it. Covered service provider here means the financial entity like a bank. More than a resolution entity, the Corporation will have the powers and responsibilities regarding deposit insurance. The amount for deposit insurance can be determined by the RC. So far, deposit insurance activity was done by Deposit Insurance Corporation of India which was an affiliate of the RBI. The Financial Resolution and Deposit Insurance, Bill 2017 will lead to repeal or amendment of resolution-related provisions in various Acts. The Deposit Insurance and Credit Guarantee Corporation Act, 1961 also will be repealed as the power is transferred to the Resolution Corporation. Methods for resolution When a financial entity is classified under critical risk ie., the highest risk grade, the Resolution Corporation can adopt any of the following five methods for Resolution of the entity: Merger/Acquisition Bail-in Transfer Bridge Service Provider Liquidation The FRDI Bill gives detailed procedures for resolving a crisis ridden entity through these methods. All these processes should be completed within one year. As per the Chapter 14 of the Bill, if the Corporation feel that liquidation is the most appropriate procedure, it shall make an application to the National Company Law Tribunal for an order of liquidation of the financial entity. The bail-in provision Regarding resolution, the bailout and bail-in are two important options. Both bail-out and bail-in have different working. In the case of bail-out, an outside agency like the government or a company helps out the distressed financial entity. On the other hand, in the case of bail-in, funds of the creditors or depositors are used to restore the institution through methods like written off, or haircut etc. So, adopting bail-in mechanism means make use of the fund of the depositors in case of resolution. A strong bail-in mechanism is an interesting feature of the FRDI Bill. As per the Bill, a Bail-in provision means use of any of the following method or a combination of them: (a) a provision cancelling a liability owed by a covered service provider (means bank to the depositor); (b) a provision modifying, or changing the form of, a liability owed by a covered service provider (means hair-cut or reducing the payment owed to the depositor) (c) a provision that a contract or agreement under which a covered service provider has a liability is to have effect as if a specified right had been exercised under it. The Bill instructs that the depositors claim in the form of deposit can be changed to shares when the regulator decides in favour of it. Here, Section 52 of the Bill that specifies bail-in mentions the following actions: (a) direct the haircutting of the collaterals and margins; (b) direct the issuance of equity to the creditors. Though the procedure for resolution is detailed, these provisions will not be applicable in full for Public Sector Banks. This is because the PSBs are owned by the government and enjoys sovereign guarantee and protection. For them, the merger/acquisition route without touching the bail-in/liquidation methods will happen. This has occurred in the past as well. On the other hand, for unviable private sector financial institutions, the extreme methods of liquidation or bail-in may be adopted. *********