How the new financial regulation law will affect the banking sector

Are the savings people slowly accumulate in their bank accounts safe? This question seems inherently counter intuitive. Banks are always associated with financial security. Anyone who deposits money in their bank accounts expects the financial institution to give them back their money when they want to withdraw it.

However, what if the financial situation of the bank deteriorates so much that it becomes unable to repay the deposits it holds? This situation of a sick bank was envisaged as far back as 1961, when the Indian Parliament passed the Deposit Insurance and Credit Guarantee Corporation Act.

Under that law, deposits of up to Rs 1 lakh, including interest, are protected by the insurance cover that the bank takes. This means that the payment of all deposits up to Rs 1 lakh are guaranteed even if the bank sinks. Anything over and above Rs 1 lakh does not have this protection, which means there is a theoretical possibility that a bank account holder with a large deposit might lose a lot of money if the bank goes down.

However, this has never happened since 1961. Figures from banking unions suggest that the 21 public sector banks, which corner 82% of the banking business in India, together pay about Rs 3,000 crores as insurance premium on deposits to the Deposit Insurance and Credit Guarantee Corporation, a subsidiary of the Reserve Bank of India. This framework, however, is all set to witness a significant shake up when Parliament takes up the Financial Resolution and Deposit Insurance Bill, 2017, for legislative approval, possibly in the upcoming Winter Session itself.

Banking unions have stridently opposed this bill for a variety of reasons. The unions said in a joint statement last month that the proposed law will open up public sector banks for liquidation or amalgamation, which could put the deposits of customers under severe risk. Worse, provisions dealing with deposit insurance are ambiguous in the draft law, with no explanation on the amount to be insured by the banks.

The bill also provides for a bail-in option, which means depositors could lose control of their money – essentially be forced to bear a loss on their holdings – which could be converted into securities such as shares in the bank in case the bank’s financial situation deteriorates.

Over and above these concerns, some people in the banking sector also feel that the new law erodes the powers of the Reserve Bank of India substantially by creating what is called a Resolution Corporation, which will oversee all matters relating to restructuring of these financial institutions.

The new law

A joint parliamentary committee is currently studying the draft Financial Resolution and Deposit Insurance Bill, 2017. The committee is expected to come out with its report soon, following which the bill is likely to be taken up for legislative approval in Parliament.

The locus of the proposed law could be found in the February 2016 Budget speech of Union Finance Minister Arun Jaitley, who said that the government was keen on setting up a framework that would instill better financial discipline among banking institutions and make stronger provisions to protect public money.

Matters moved swiftly after this announcement. A committee under Ajay Tyagi, additional secretary of the Department of Economic Affairs, was set up in March 2016. The committee released the draft law in September that year. The government gave the public less than 20 days to comment on the draft bill, and this process of discussion was closed on October 14, 2016. The following June, the Union Cabinet cleared the bill, which was later tabled in Parliament in August, just a day before the Monsoon Session came to an end.

Political parties, including the Congress and the Trinamool Congress, expressed their displeasure at the manner in which the bill was tabled and also criticised the move to form a new joint committee to study the draft when a select committee for finance was already available.

The Resolution Corporation

The primary concern expressed by banking unions is the provision in the law that creates a new Resolution Corporation.

CH Venkatachalam, general secretary of the All India Bank Employees Association, said that so far, the Reserve Bank of India had exclusive powers to determine the financial health of a bank and recommend remedial measures in case banks got into financial trouble. But the proposed Resolution Corporation will usurp this crucial power, thereby weakening the regulatory role of the Reserve Bank of India.

“The new law seeks to amend all exclusive laws governing financial institutions, including the State Bank of India Act,” he said.

The proposed Resolution Corporation will determine if there is an “imminent risk” of the bank failing financially and will trigger what it feels would be the right remedy. It will also replace the Deposit Insurance and Credit Guarantee Corporation and take over the role of providing deposit insurance.

According to Chapter II of the bill, the corporation will have a chairperson and one representative each as ex-officio member from the finance ministry, the RBI, the Securities and Exchange Board of India and the Insurance Development and Regulatory Authority. It will also have a maximum of three full-time members appointed by the Union government, and two independent members. Banking unions said that the very composition of the corporation will give supreme powers to the Union government rather than the RBI to determine the fate of a bank.

Thomas Franco of the State Bank of India union said that the new bill raised a larger systemic question. “The State Bank of India Act makes it clear that the bank cannot be liquidated,” he said. “The new law is getting rid of this important provision.”

Franco added that the Bill, in the form it is currently in, looks like the launching pad for further diluting public sector banks. “Instead of taking on the non-performing assets problem, which was created by corporate defaulters, the government is attempting dilution of banks,” he said.

The government, however, has consistently maintained, as seen from the objectives of the bill itself, that the new law will only bring in more financial discipline. It will compliment the new bankruptcy code put in place in 2016 that aims at recovering defaulted loans.

Venkatachalam pointed out that the law gives all powers to the Company Law Tribunal in case of liquidation. This, in the context of public sector banks, is unwarranted. “The public sector banks are currently not covered under the Companies Act,” he said. “So why this provision? They should continue to be governed exclusively by the Banking Regulations Act.”

Under the proposed law, no court other than the Company Law Tribunal will be able to take cognisance of disputes on liquidation.

There is also a major concern of the violation of labour rights. There are clauses in the bill that enable the Resolution Corporation to terminate employment or change the compensation structure of bank employees when the bank goes through various stages of resolution. The employees may not be able to claim compensation for loss of employment, which, unions said, is a direct violation of the right to constitutional remedies guaranteed under Article 32 of the Constitution.

The bail-in clause

The bail-in clause included in the proposed law is perhaps the provision that immediately affects depositors.

A bail-in clause is one where the creditors of the bank would be forced to bear a part of the loss in case the institution sinks. All depositors are considered creditors in banking terms. In fact, they are unsecured creditors, in the sense that no depositor seeks security from banks while making their deposits. The bank uses these deposits to extend loans and earn interest.

Under the proposed bill, a bail-in will be triggered in consultation with the appropriate regulator, which in the case of banks would be the RBI, if the proposed Resolution Corporation is satisfied that a bank needs a dose of capital to absorb losses and continue to function without breaking down. This clause excludes insured deposits, which, under existing rules, means a sum of up to Rs 1 lakh with interest would be protected. The rest of the amount could be converted into securities like stocks of the bank.

A senior banking executive of the Indian Bank said on condition of anonymity that this was perhaps an improvement from the existing scenario, where amounts over Rs 1 lakh would be lost completely. “Your money will be converted into a security instead of being lost,” the banker said.

But Franco is not convinced by this argument. “There is an assumption here that the bank will recover after the capital infusion,” he said. “What if it doesn’t? What will be the worth of the equity then?”

Also, depositors put their money in public sector banks because they know the government will bail out the bank if it collapses. But through the new bill, the government is virtually indicating that there will be no bail out from its side.

“This bail-in provision will only create panic,” said Franco. “The moment news gets out that a bank is financially sick, there will be a rush to take deposits out as confidence of a government bail out does not exist.” This will only expedite the fall of the bank.

Those opposing the new law argue that its fundamental idea is to transfer the burden of non-performing assets created by corporate defaulters to the common people. “Bail-in means bailing out big corporate defaulters,” Venkatachalam alleged.