Reimaging Bank Resolution in India: Post-FRDI Model with Global Insights

[Disha and Shivam are students at Hidayatullah National Law University.]

A strong banking system is the backbone of both developing and developed economies. It requires well-drafted laws, strong regulatory mechanisms, and flexibility to adapt to the dynamics of a growing economy like India. Incidents like the Yes Bank crisis highlight the systemic risks posed by failing banks in the absence of a clear resolution mechanism. The response of Reserve Bank of India (RBI), in such situations, is ad hoc and lacks transparency, and does not contribute to building public confidence or provide a lasting solution. Therefore, a key requirement of a strong banking framework for India is a model of resolution of failing banks. In this context, it can be helpful to understand international banking resolution models, which provide structured regimes, empowering authorities to resolve troubled banks without systemic disruption.

According to the EU’s Single Resolution Board, bank resolution means a process of bank reconstruction by specified authorities, using systematic tools to ensure public interests and continuity in core banking services. It is a process similar to corporate insolvency resolution; however, it is specially designed for banking entities. The need for a designated legal framework for bank resolution arises from the fundamental difference between a bank and other corporate entities, in terms of the specific nature of operations and objectives pursued. 

A bank failure, as against a corporate insolvency, is likely to have a ‘domino effect’, i.e., disrupting the functioning of other banks and financial institutions. This is because banks operate in a highly interconnected ecosystem, and bank failures have larger implications for the economy in the form of credit contraction and deterioration of depositors’ confidence. 

This article examines the possibility of developing an effective bank resolution authority. Firstly, it analyzes the current Indian legal framework for bank resolution, including the failed Financial Resolution and Deposit Insurance Bill 2017 (FRDI Bill). Secondly, it explores relevant international models for bank resolution, drawing lessons for India. Thirdly, on the basis of the previous analysis, it proposes policy recommendations for charting the way forward. 

Indian Legal Framework: Law and Challenges

In India, banking failures are primarily addressed by the RBI, with no specific rules or statutes for their resolution. RBI relies on its general powers under Section 45 of the Banking Regulation Act 1949 (Act). It empowers the RBI to apply to the Central Government for a moratorium and prepare a scheme for the reconstruction of banks, which may provide for, inter alia, matters including ‘the capital, assets, powers, rights, interests, authorities and privileges, the liabilities, duties and obligations’. Once notified, the scheme binds all stakeholders, including depositors and shareholders. 

Apart from Section 45, the Central Government is equipped with the powers to reconstruct specific categories of banks, like public sector banks and regional rural banks. Under Section 38 of the Act, the High Court can also wind up a banking company in case of failure to repay its debts or on application by the RBI. While these provisions may be useful in emergencies, they do not provide any specific tools to address bank insolvency and involve no prior planning. Additionally, actions taken under these provisions lack transparency, since there is no independent authority involved. 

The regulatory vacuum in India’s banking resolution framework has not gone unnoticed. In 2017, the FRDI Bill was introduced in the Parliament of India. The FRDI Bill provided for the constitution of a ‘Resolution Corporation’, an independent body to identify failing banks and empowered it to use various resolution methods, like transfer of assets and liabilities of the entity to another entity, mergers and acquisitions, bail-in provisions or dissolve the bank to pay back to the creditors, to revive a failed bank. However, the FRDI Bill faced intense criticism due to the bail-in provision, which allowed the authorities to use creditors’ and depositors’ funds to be converted into equity for recapitalization of the bank or be written off. This provision undermined the public trust in the banking system by instilling fear among consumers about the safety of their funds. Hence, the FRDI Bill was withdrawn in 2018. In this context, it is beneficial to examine the present global framework governing bank resolution.

International Perspectives: Models and Mechanisms

The International Institute for the Unification of Private Law (UNIDROIT) Governing Council recently adopted the Legislative Guide on Bank Liquidation (Guide). It is drafted by the Working Group on Bank Insolvency, with the objective of guiding legislators and policymakers to draft a harmonized framework for the orderly liquidation of banks across jurisdictions. An important characteristic of the Guide is its applicability to all kinds of banks, irrespective of their form and structure. This model suggests that the grounds for initiating a bank liquidation should be broader, and it focuses on proactive approaches like early warnings of non-viability to take swift action. It grants liquidators robust transfer powers to protect depositors, similar to ‘Purchase and Assumption’ transactions. Moreover, the Guide calls for legislating rules on the systematic liquidation of banks operating within group structures, to ensure the other entities in the group remain unaffected. 

In the UK, the Bank of England is the primary authority undertaking activities concerning banking resolution. It draws authority from the Banking Act 2009, which provides for the Special Resolution Regime (SRR), which is specifically designed to resolve financial institutions in a timely and orderly manner. The Bank has to consult entities like the Financial Conduct Authority and the Prudential Regulation Authority to identify a clear need for resolution. His Majesty’s Treasury is consulted to determine whether resolution is to be triggered and what tools should be used. Resolution can take place only if the “public interest” test is satisfied, when a banking firm is “failing or likely to fail” and its revival is unlikely. It provides five stabilisation tools, which include a bail-in mechanism and temporary public ownership. Although the Bank has significant powers to alter the contractual rights of creditors and shareholders, there are safeguards in the form of compensation arrangements and the carrying out of an independent valuation of assets and liabilities. Thus, the UK provides a comprehensive and balanced regime for the resolution of failing banks.

In the United States, a single-track regime is provided under the Federal Deposit Insurance Act 1950 (FDIA). It grants powers upon Federal Deposit Insurance Corporation (FIDC) to exercise mechanisms for bank failure resolution like setting up a bridge bank to continue the operations of a failed bank, or transferring the assets of a failed bank in a ‘Purchase and Assumption’ transaction or wind-up the institution and distribute the assets among the depositors and creditors. 

Policy Roadmap for India: Adopting Global Best Practices

The foregoing analysis of India’s attempt to regulate failing banks through the FRDI Bill and the comparative international models reveals several areas of improvement. It can be used as a basis for determining the future policy of India concerning bank resolution. An approach that is suited to the Indian legal and financial context, yet inspired by global standard practices, is best poised to address the uncertainty surrounding bank resolution in India.

First, a specific independent authority should be established to regulate the liquidation process of banks in India. Similar to the UK’s Bank of England, this authority should engage in pre-resolution consultation with other regulatory bodies like the Securities and Exchange Board of India, the Insolvency and Bankruptcy Board of India, the Ministry of Finance, etc., for the effective resolution of failed banks. Currently, the RBI, which itself is the regulator of banking operations, acts as the authority to decide their viability, leading to excessive concentration of authority. Mandatory consultation with other entities would lead to decentralization and allow stakeholder participation.

Second, broad powers should be conferred upon these authorities, like the US’s FIDC, to navigate between several courses of action and apply the most suitable one for the specific case. Additionally, the risky solutions, like bail-in provisions, should be invoked in the specified exceptional cases, and the affected consumers must be adequately remedied, which can be pre-determined based on the extent of the amount utilized.

Third, India must, relying on the UK’s SRR, provide clear criteria by incorporating defined terms like “failing or likely to fail” and “public interest”. The law should aim to strike a fair balance between qualitative factors and quantitative factors, by incorporating objective factors like persistent negative net worth, extreme deterioration of assets without a parallel decrease in liabilities, etc. Based on the Guide, India should also include broader grounds for bank liquidation to ensure timely and efficient resolution.

Lastly, it must be recognized that the bail-in provision is not always contrary to public interest, provided it is well-designed to incorporate safeguards. Such safeguards must inspire depositor confidence by setting minimum and maximum amounts that can be utilized during the resolution process, from both retail and institutional depositors. It must specifically protect small family and personal depositors. It must not be compulsory for all accounts, and provide a higher rate of interest for those opting for it, incentivizing willing depositors.

Conclusion

India’s banking system stands at a crucial threshold in the world economy. In light of the emerging complexities and a consequent need for a designated framework to tackle the failure of banks, India must move beyond ad-hoc mechanisms and create a proactive and accountable framework. The positive externalities of a sound banking system, which inevitably requires a strong resolution mechanism, include improved depositor confidence, increased foreign investments, and overall mutual benefits of corporations and consumers alike.

International frameworks like UNIDROIT’s Legislative Guide, the UK’s SRR, and the US’s FDIA offer compelling examples of how well-defined and structured regimes can operate without causing systemic disruptions. India’s tryst with the FRDI Bill showcases that the need for a specific law for bank resolution has been recognized. The concerned authorities must rise to the occasion and design a balanced resolution framework addressing the same.