It is time to bring the resolution corporation back on the table

In this article Radhika Pandey and D Priyadarshini argue in favour of setting up of Resolution Corporation for financial firms to minimise disruptions of economic activities and protect depositors interests.

Hyderabad: In his recent speech at the 7th SBI Banking and Economics Conclave organised by the State Bank of India, the RBI Governor rightly stressed on the need for preserving financial stability while focusing on economic growth.

He also underscored the need for establishing legislative backing for a Resolution Corporation to resolve stressed financial firms. This is very much the need of the hour.

A key lacuna in the Indian financial regulatory architecture today is the absence of an independent and dedicated framework for swiftly resolving troubled financial firms.

A number of expert committees in the past notably, the Financial Sector Legislative Reforms Commission and the Committee to Draft Code on Resolution of Financial firms, have called for a specialised resolution regime for financial firms.

While the Insolvency and Bankruptcy Code (IBC) has since been enacted to provide a framework for insolvency and bankruptcy of non-financial firms, there still exists no such framework for resolving financial firms.

Further, while the IBC was extended last year to include certain NBFCs (i.e., with an asset size of Rs. 500 crore or more), financial entities like banks and other systemically important NBFCs remain outside the framework.

In any event, the amendments are an interim measure until a full-fledged legislation is enacted for resolution of banks and other financial entities.

The IBC process is also not appropriate for resolution of all financial firms. For instance, the creditor led process under IBC may not be feasible for banks where the principal creditors are the large number of depositors.

Financial firms are different from non-financial firms in that they handle consumer's money.

Some financial firms are also systemically important as their failure can adversely impact the economy.

Prompt resolution is therefore imperative as often, consumer interests can be better served if the firm can be sold as a going concern with minimum disruption to the economy.

The current framework does not address this as it only allows for sub-optimal options like mergers of troubled banks (with a stronger bank) or liquidation.

Further, with the RBI being both a banking regulator and a resolution authority, it becomes necessary to separate both functions and establish a dedicated resolution corporation for banks, to avoid conflicts of interest.

The need for a resolution corporation is particularly critical at this juncture.

Over the last two years, and prior to the pandemic, the financial system has witnessed crisis in the form of collapse of prominent financial entities like IL&FS, DHFL and Yes Bank.

PMC Bank is already in trouble and other cooperative banks showing signs of trouble.

These vulnerabilities will be amplified once the moratorium on repayments is lifted.

While the RBI Governor has called for increased capital buffers to safeguard banks' balance-sheets and build resilience, it is possible that some banks would face significant erosion in balance-sheets, decline in profitability and surge in stressed assets.

During the Yes Bank crisis, in the absence of a resolution framework, the ultimate policy option was to ask State Bank of India and a few private sector banks to bail out Yes Bank.

Such policy responses would however be difficult once the moratorium is lifted as there are a limited number of healthy public sector banks and they are likely to face deterioration in the quality of their assets.

An independent and dedicated resolution corporation would be a complement to the surveillance and supervision of financial firms. It would provide a quick and orderly exit to failing entities so that capital and assets can be freed and put to more productive uses.

Bring back FRDI Bill

The most credible policy option then is to bring back the Financial Resolution and Deposit Insurance (FRDI) Bill which proposed a Resolution Corporation.

The Resolution Corporation, along with the regulator, would monitor financial firms, take corrective actions in accordance with the risk of failure, and resolve them once a firm reaches a threshold risk of failure.

It will also provide deposit insurance in the event of liquidation of the firm.

The bill was introduced in 2017 but was withdrawn subsequently due to the controversial bail-in clause. The Bill should be brought back on the agenda of financial sector reforms - the controversial clauses can be dropped.

In recent times, the government has shown tenacity in introducing various structural reforms.

Nearly 1500 urban cooperative banks have been brought within RBI's oversight with immediate effect.

Ordinances have been brought allowing farmers to contract freely for production and sale of crops without going through intermediaries like traders or Agricultural Produce Marketing Committees.

Hopefully, with RBI also lending support to this badly needed reform, the establishment of a Resolution Corporation should see the light of the day sooner rather than later.

(Written by Radhika Pandey and D. Priyadarshini. Authors are Fellows at the National Institute of Public Finance and Policy, New Delhi. View are personal.)