[Chhavi is a student at Jindal Global Law School.]
Resolution is the process of restructuring banks while safeguarding public interest, depositors’ interests, and continuing critical banking functions. In the Indian context, the resolution of banks and insolvency proceedings are governed by the Insolvency and Bankruptcy Code 2016 (IBC) which also governs corporate insolvency in India. Most jurisdictions, be it developing countries or developed ones, have a separate law for resolving banks.
How are Financial Institutions Different from Non-Financial Corporates?
Banks and other non-banking financial institutions (NBFC(s)) are very different from non-financial companies. Banks and NBFCs play a very critical role in a country’s economy. They are direct sources of liquidity and credit creation for any economy. They are interconnected within themselves and the economy. Considering the main functions performed by banks, if there are concerns regarding a bank’s financial viability, the “value of the bank franchise dissipates very rapidly.”[1] “The bankruptcy costs of a bank failure are considerably higher than the bankruptcy costs of a non-financial firm” (emphasis supplied).[2] The negative externalities of bank failure become far more serious due to the interrelatedness of banks and financial institutions with the entire economy leading to a contagion effect / domino effect[3] and the spread of the failure or crisis in other regions and other financial companies, respectively.
Why is There a Need for a Separate Law?
Standard insolvency and bankruptcy laws, like the IBC in the Indian context, are not best suited for resolution of banks and other financial institutions (FIs) as they are situated very differently from non-financial companies/institutions. Initially, it was envisaged that the resolution of FIs would happen under a separate law and the Financial Resolution and Deposit Insurance Bill 2017 (FRDI Bill) was passed by the Parliament which was later withdrawn due to concern over the bail-in clause and deposit insurance cover.
The main objective of bank insolvency is ensuring the stability of the financial sector as opposed to general insolvency and bankruptcy rules like the IBC which aims to resolve claims of creditors and maximize returns for them. Under standard insolvency laws like the IBC, the focus is generally on protecting the creditors and the shareholders, with no mention of depositors in the order in which claims of different stakeholders are paid off. However, protecting depositors’ interests and preserving financial stability is the goal of all bank resolution laws in the world. The IBC was never meant to be applied to FIs and banks, but it can still be used for the resolution of banks or FIs under Section 227 of the IBC on directions from the Central Government or on the authorization of the RBI by the Central Government to invoke IBC for bank resolution under Section 35AA of the Banking Regulation Act 1949. In November 2019, the Ministry of Corporate Affairs passed a new set of rules to expand the scope of the IBC to include financial service providers within its ambit.
Corporate insolvency procedures are largely centered around negotiations involving creditor committees whereas the onus to give due regard to creditors and shareholders’ rights is on the bank regulator or supervisor on whose direction the resolution process is initiated. The rationale is that the object of corporate insolvency is to maximize returns for the creditors whereas the objective of bank insolvency is to prevent systemic problems and ensure stability of the economy while continuing critical banking functions and cushioning the damage to the banking system. Under the IBC, the insolvency process called the corporate insolvency resolution process kicks in only upon the occurrence of a default by the debtor. In the case of banks and other FIs, pre-emptive measures for preventing at-risk banks from going bankrupt are also very important given the large-scale systemic risks associated with such financial distress. The Insolvency and Bankruptcy (Insolvency and Liquidation Proceedings of Financial Service Providers and Application to Adjudicating Authority) Rules 2019 (Insolvency & Bankruptcy FSP Rules) provide for the institution of CIRP against financial service providers (FSP) only on the occurrence of default by such an FSP under Section 4.
Resolution of banks requires different tools which general corporate insolvency laws do not envisage. According to the Basel Committee on Banking Supervision, “national authorities should have appropriate tools to deal with all types of financial institutions”. The failing bank assets with rapidly decreasing value need to be resolved timely. The Financial Stability Board issued some key attributes for effective resolution of financial institutions which state that laws for effective resolution should provide for resolution tools such as transferring ownership of assets, and liabilities, critical functions to bridge banks, sale of non-performing assets, converting unsecured debts or liabilities to equity. The IBC is not equipped to use such resolution tools, whereas special insolvency laws for financial institutions in the US and the UK are. Transfer of assets, for instance, can be done much more rapidly if standard bankruptcy procedures are not followed and speed is key, to cushion the impact on the economy. Typically, the RBI has only two tools at its disposal- winding up or compulsory amalgamation/merger of a financially weak bank with a more stable bank. Resolution of FIs should be carried out by administrative resolution authorities in the interest of speed and efficacy. The Reserve Bank of India is significantly involved in resolutions of FIs and banks despite not being equipped to carry out such procedures.
The Government of India recognizes the need for a more efficient regime for the resolution of banks and protection of the interests of the depositors, which led to the introduction of the FRDI Bill in 2017. However, it had to be later withdrawn in 2018 due to opposition from depositors and stakeholders to the bail-in provision which allows either for writing down/canceling the liabilities of the institution, or conversion of debt into equity. Creditors were dissatisfied despite the fact that Section 55 states that creditors shall end up “redeeming more value of their claims than what they would be entitled to in case of a waterfall provision upon liquidation of the bank.”
Another concern is that the prudential regulator for financial institutions, the Reserve Bank of India in the Indian Context, should not be responsible for the resolution proceedings of financial institutions. If the supervising body is also made responsible for conducting the resolution process for FIs, any failure of an FI will reflect poorly on the supervisory function performed and it will be in the supervisor’s interest to delay the initiation of insolvency and resolution proceedings against FIs. A separate body is needed which has the appropriate resolution tools as well. An RBI Working Group itself has recommended that a single authority for the resolution of financial institutions is needed and the Deposit Insurance and Credit Guarantee Corporation should be given powers to act as receivers and liquidators of failed banks. The Ministry of Finance also recommended in 2016 that an independent body called the Financial Resolution and Deposit Insurance Corporation should be set up for performing resolution functions for financial institutions.
Continuity of banking functions and access to the market is critical for the stability of the economy overall. Corporate insolvency processes impose a blanket moratorium on enforcing claims, which would make continuity of critical functions very difficult. While a moratorium is important to ensure that resolution authorities can consider available options without facing pressure from creditors trying to enforce their claims. However, blocking all payments and claims will not be appropriate “given the needs of bank customers and households.” The Insolvency & Bankruptcy FSP Rules provide for an interim moratorium from the date the application for resolution is filed. While the said moratorium does not extend to “third-party assets or properties in custody or possession of the financial service provider”, what third-party assets/properties mean is not defined clearly. More clarity is needed to ensure that creditors do not end up suffering.
We need specialized provisions incorporating the attributes discussed above for effective resolution of banks and other FIs.
The Way Forward
The FRDI Bill was a welcome move as it has many of the important attributes needed for the resolution of financial institutions. Additionally, as opposed to common understanding, the bail-in tool cannot be used as per the government’s fancies and there are many checks and balances in place. However, to further protect depositors, the coverage of depositor insurance may be increased “in accordance with the savings of middle-class households.” A ‘bail-in clause’ should be used only as a last resort and its impact on other creditors should be properly considered. With these few changes, the FRDI Bill can be made even better and it will become more depositor and creditor friendly. A separate resolution regime for banks is something India desperately needs to properly tackle bank failures and ensure stability of the economy.