A Recipe for Disaster – FRDI Bill and the Bail-In Clause

The Financial Resolution and Deposit Insurance (FRDI) bill, which the government is planning to pass in the coming parliamentary session raised a lot of hackles and put fear in the hearts of the bank depositors. An assurance by the Finance Minister that the FRDI bill is meant to safe guard the interests of the depositors has done nothing to calm the situation.

What is there in the bill that threatens the interests of the depositors?

Among other things, the it proposes to give the Resolution Corporation which going to be formed, sweeping power in resolution of any troubled banks. The powers of the Corporation range from mergers, amalgamations and liquidations of banks to allowing the banks to be bailed-in with the funds of the depositors. This so called bail-in clause is what is sending jitters through the spines of the Indian depositors.

According to the bail in clause, the Resolution Corporation can allow a stressed bank to covert part or all of depositors’ money in to capital. For example, a bank which has huge amounts of NPAs can be directed by the Resolution corporation, to get adequate capital by converting a certain portion of its deposits in to capital. If depositor A, has Rs. 10,000 in a stressed bank, the corporation may direct the banks to covert Rs. 5,000 of the deposit in to capital. This means A can only access Rs. 5,000 of the original amount he deposited. When or if he will get the remaining Rs. 5,000, one is not sure.

Most Indians keep their savings, which they have set aside for all kinds of contingencies - marriages, health emergences, education etc, as bank deposits. Bank deposits allow them to withdraw their savings with a short notice, while carrying little risk – unlike investments in equities and mutual funds. But, the bail-in clause means that banks will be rescued at the expense of depositors. It means that bank deposits are as insecure and as illiquid as any stock market instrument.

Such a bail-in plan has seen depositors lose 47.5% of the value of their deposits in Cyprus. This 47.5% of the deposits was used to recapitalise the sinking bank. The bail in clause of the FRDI bill comes with the same risk to Indian depositors.

With the bail-in clause, Indians are now caught between rock and the hard place. Keeping savings in the form of cash is a difficult option thanks to demonetisation and the continuing shortage of cash as well as the threat of a future demonetisation. The bail in clause means, even bank deposits would not be a risk-free option, any more.

If, credit card companies and e-wallet companies reaped the benefits of demonetisation, the bail-in clause is going to serve public savings on a platter for the big corporates. Corporations of Ambanis and Adanis can refuse to pay back their bank loans– while depositors pay for it.

The bail-in clause making the savers wary of depositing their funds in the banks, they will be forced in to equity markets and mutual funds. This will not only put savings at risk, but will provide cheap and easy funds to the corporates. As savings flood in to equities, the valuations of corporations will go through the roof and India’s billionaires will soon be on their way to becoming trillionaires. And, when markets crash, as they usually do, the life savings of millions will be wiped out.

What is the urgency of this FRDI bill and the bail-in clause?

The fact is, Bail-in concept has been canvassed in G-20 meeting by the developed countries in 2014, in the back ground of the 2008 crisis – during which US and the European banks were bailed out by their governments. India is now blindly following this, even though the conditions in its own banking sector are entirely different.

India never had a banking crisis of the kind seen in the west, for example, the recent 2008 crisis. Indian banks have been under periods of stress, when banks were burdened with NPAs, as during the 1990s and at present as well. Yet, there has never been a bank run, during which depositor’s savings were at risk. If ever there was small crisis, RBI always managed it. For example, in 2003 when Nendugadi Bank, a smaller private sector banks, turned sick, under RBI’s guidance Punjab National Bank took over the business, with out any loss to the depositors. The DICGC hardly ever had to step in and pay up for deposit losses, except very minor amounts in case of some small co-operative banks.

A strong presence of public sector banks and the implied sovereign guarantee, provided the Indian banking sector a stability that is not enjoyed by the American or the European banking systems. Unlike these countries, long ques of panicked depositors outside the banks is an alien scene in India.

Yet, the bail-in clause has the risk of precipitating, what it explicitly is supposed to prevent - a banking crisis, which never occurred in at least the last 50 years in India. Once, depositors become familiar with the bail in clause and the potential of deposits being converted to capital, there is a danger that they will que up to withdraw their deposits at every rumour and whiff of the smallest trouble. This will then become a self-fulfilling phenomenon, with a domino effect across the banking sector – precipitating in an actual banking crisis. If government wants to save the economy, then it will have to step in and bail out the banks any way. This makes the bail-in clause useless at best and dangerous at its worst.

If government is really interested in preventing banking crises, the best it can do is to continue with the present system and junk the FRDI bill and the bail-in clause with it. It would be more fruitful for the welfare of the banks and the country, if it concentrates on getting back the so called NPAs – the funds that corporates have robbed from the Indian banking sector.