It was understood that FSDR is to replace the Financial Regulation and Deposit Insurance Bill, 2017 (FRDI). Unlike FRDI, the FSDR draft is not available to the public, so one wonders why FRDI was to be replaced by FSDR, which is aimed at the rescue of banks – among other financial institutions – from collapse. Therefore for a start, it is pertinent to discuss banks before going on to FRDI and FSDR.
Trust-factor in banking
Banks receive deposits of earnings and savings of investors, who in turn receive interest on their deposits. The bank makes a profit by loaning these moneys and earning interest on the loans, while maintaining sufficient funds to pay interest to its depositors (their creditors) and assure them the return of their deposits on demand. Though simplistic, this is the essential description of banking.
The basis of banking transactions is the institutional trust of millions of people, especially senior citizens, that the bank will safely and honestly administer their earnings and life savings. However sometimes, banks fail them not only financially but equally importantly in terms of trust.
Failure or incipient failure of banks is not new, and there are many reasons for it. Among the most prominent reason today is mounting bad loans provided by banks. Banks are unable to, or under influence of powerful lobbies asked not to, recover the interest from the loanees, leave alone the principal amount. These bad loans are held in the books as non-performing assets (NPAs). The bank approaches collapse when NPAs rise to a sizeable percentage of the bank’s capital.
Collapse of a bank would have enormous repercussions on public trust in the banking-financial-economic system. So when a bank is on the verge of collapse, alarm bells start ringing in the finance ministry. It then bails out the bank by infusing public funds to re-capitalize the bank [Figure 3], not unlike blood transfusion for a wounded patient in an intensive care unit. Successive governments have used the bail-out process to resolve banks’ NPA-based financial crises, so as not to raise public investors’ fears or affect the vital trust factor.
NPAs and the economic system
In terms of value, NPAs are 86% corporate and 14% small borrowers, including farmers. Whereas around 72% of GDP is generated by small businesses (unincorporated proprietor and partnership firms and MSME), only around 18% is generated by the corporates.
It is apt to quote Prof R Vaidyanathan: “The unincorporated or the non-corporate sector in India is the largest contributor to national income, savings and investments and taxes, and accounts for the largest share in manufacturing and service activities and employment. Yet, it is a victim of the myth of superiority [emphasis added] surrounding the corporate sector”. [“India Uninc”; R Vaidyanathan, 2014]. This remains true even today.
Over decades, operation of the economic system has resulted in 1% of the population owning over 50% of wealth, 77% of total national wealth held by the top 10%, and the richest 1% getting 73% of wealth (2017), even while 67 million Indians comprising the poorest half of the population increasing their wealth by merely 1%. All this is pre-Pandemic, and reveals a politician-bureaucrat-corporate nexus growing at public cost.
Governments favour corporates
Before or after bail-out, banks also write-off NPAs from their books. There are several past instances, the most recent being SBI “prudentially” writing-off Rs1,23,000-crore while recovering only Rs.8,969-crore from borrowers over eight years from FY2013 to FY2020. (Read: SBI Writes Off Rs1.23 lakh Crore of Bad Debt, Recovers Paltry Rs8,969 Crore in 8 Years!
). Such “prudence” amounts to waiving the borrowers’ liability and effectively transferring the difference, namely Rs1,14,031-crore of public money, to wilful defaulters.
In April 2020, Reserve Bank of India (RBI) had said that Indian banks have written-off Rs68,607-crore due from 50 top wilful defaulters, including the absconding diamantaire Mehul Choksi.
Indications are that 80% of Rs7-lakh-crore of bad loans in the last decade were written-off in the last five years. Such exercise of financial prudence reveals government’s bias favouring wealthy borrowers at public cost, and could lead to the public losing trust in government’s management of public finances. It is only fair to point out that such a bias has been unabashedly displayed by successive earlier governments following the 1991 New Economic Policy.
This bias is amplified in successive union budgets up to the present, by foregoing revenues from corporate tax and customs and excise duties amounting to many lakhs of crores of rupees. Although this is done to “incentivize industry” by providing them money in hand for expansion/growth, it is governments’ annual, self-inflicted blow on expenditure towards public health infrastructure, housing, education, welfare, and farmers, which benefits the majority population. (Revenue foregone to corporates estimated at Rs1,08,785 crore
From bail-out to bank mergers
The NPA crisis is expected to worsen, with a “pile of bad loans” adding up to Rs20-lakh-crore by year-end. (Indian banks are in for a ‚20-trillion hole
) NPA growth by borrower-default is due to the economic impact of the Corona pandemic and capital erosion of banks, calling for their re-capitalization, according to RBI governor Shaktikanta Das.
Government took the measure of merging ten PSBs effective 1 April 2020. It is pertinent to note that the decision to merge would have been taken because of the pre-Pandemic precarious situation of NPA-hit PSBs. Merger of PSBs has the advantage of preventing bank collapse by merging the liabilities of the collapsing bank with a bank declaring lower liabilities. However, insofar as NPAs are concerned, it is an ineffective, cosmetic band-aid dressing on the NPA wounds, with no curative effect.
Government’s financial crisis is due to concatenated global and domestic financial circumstances including demonetization and unprepared GST rollout, on top of regularly foregoing revenues in favour of big business. Today, government has no money to re-capitalize banks using the bail-out resolution process as hitherto done, and merger of banks as a resolution measure has already been resorted to.
It is more than probable that the government will resort to rescuing failed/failing banks using the earnings and savings of its people. That is, bail-in is a near certainty.
The bail-in fear
In 2017, when FRDI draft became available for comments, some noticed that it included means for NPA-affected banks to re-capitalize using the moneys of its depositor-creditors by a process called “bail-in” [Figure 4], and savings were only safe to the extent of the insured deposit amount at government’s discretion. Noting that 58% of bank deposits are the small deposits of millions of citizens, it is no wonder that the bail-in clause triggered serious apprehensions, even though government had assured that fears were “misplaced”. (FRDI Hajamat
Perhaps the small investor did not believe government’s assurance, but the bail-in clause of FRDI punctured the trust of large numbers of small creditors, who feared benefit to the NPA-causing corporate borrowers responsible for around 80% of NPAs, at their financial cost.
Briefly, FRDI “... had triggered panic among depositors over the controversial ‘bail-in provision’ which held out the threat of forcibly converting term deposits with banks (above a certain insured threshold) into equity to recapitalise failed banks”
. (Read: FRDI Bill To Come Back as FSDR: Many Questions Unanswered
). Thus, following the outcry, government announced in 2018 that it had withdrawn the FRDI Bill.
The FSDR Bill
What is known about FSDR is from articles and YouTube interviews, since government has not made the draft available to the public. The reason for secrecy is difficult to understand especially since the law when operationalized, will concern/impact millions of individuals, institutions and public funds.
According to FSDR, the means for resolution of financial sector entities, like stock exchanges, clearing authorities and depositories or other capital market and insurance market intermediaries, when they fail, are inadequate. Therefore it establishes a comprehensive and effective resolution regime for the financial sector, of which banks are perhaps at the core.
FSDR is a legislation to save financial institutions from bankruptcy caused by financial imprudence, mismanagement, failure of due diligence, defalcation, fraud, etc.
Resolution is done by a financial resolution authority (FRA), a government-owned corporation with absolute authority to undertake resolution measures. It will
# Assess vulnerability of a financial service provider (a bank) to failure, depending upon its exposure (NPAs, etc),
# Grade its risk as low, moderate or imminent/critical, and
# Resolve the bank at imminent/critical risk.
Resolution options are # Bail-out, # Merger with another financial entity, or # Transfer its NPA liabilities to other financial entities.
FRA is also empowered to “terminate contract”, write down the debt, and modify the liability of the financial entity under resolution. That is, the contract between the depositor and the bank can be terminated, the bank’s debt to its creditors (depositors) can be written down, and the bank’s liability to protect the deposits of its investors can be modified. These resolution measures are precisely bail-in cloaked in technical jargon.
FSDR implicitly assumes that consumers’ deposits are vulnerable to the risk of bail-in. So FRA provides insurance at its discretion. At best (for the depositor), it can keep individual deposits on hold and, with a no-appeal finality, disburse deposit insurance at its discretion.
Scams of mismanagement, financial imprudence, defalcation, fraud, etc., among financial service providers, and growth of NPAs taking PSBs to the brink of collapse, are causes for public disquiet because personal savings are at stake.
Government has no finances to bail-out failed/failing PSBs, even as it writes-off big borrowers’ NPAs (86%), and foregoes revenues favouring corporates which contribute only 18% to GDP. It is worrying that FSDR helps truant corporates by re-introducing disguised bail-in which threatens small depositors’ savings.
Whether FSDR actually does or does not include disguised bail-in will only be known if the finance ministry provides the draft for public information and comments, giving adequate time. Only this can show whether or not the government cares for the people and values their trust.
(Major General SG Vombatkere, VSM, retired in 1996 as Additional DG Discipline & Vigilance in Army HQ AG's Branch. He holds a PhD degree in Structural Dynamics from IIT, Madras. He is Adjunct Associate Professor of the University of Iowa, USA, in international studies.