Bail-in clause: don't do another DeMo on common man

The Financial Resolution and Deposit Insurance (FRDI) Bill, 2017, which received cabinet nod earlier this year and is now being studied by a Joint Parliamentary Committee, has created much concern in the media, and rightly so, by virtue of the 'bail-in' clause, under which a distressed or insolvent bank, in restructuring its liabilities, can force its creditors to take a haircut - that is, absorb the losses by having a portion of their debt written off.

This has understandably raised the hackles of millions of depositors - largely comprising small savers - who entrust their monies in the form of fixed deposits with the banks in the belief that FDs are the safest form of small-time savings.

In contrast to bail-ins, under the conventional "bail-out" clause, it was the more diffused outsiders, typically the government or the taxpayers, who had to fund failing banks out of bankruptcy.

Bails-ins entered the financial lexicon after the 2007-08 financial crises in US and then Europe, when government bail-outs of banks came in for severe criticism. That's when the US and then the EU introduced bail-ins through Bank Recovery and Resolution Directives (BRRD) in varying measures. Canada was the last country to introduce this clause earlier this year.

That said, the move has raised concerns of depositors worldwide and different countries have responded differently to these concerns; some, for example, by setting a relatively higher ceiling for guaranteed deposits, and others by excluding bank deposits from any bank recapitalisation efforts at all.

It has been well-recognised internationally that where the ceiling of guaranteed deposits is set low, as is the case in India at Rs 1,00,000, larger depositors could well migrate to other potential investment options, like money market funds or even investment funds that offer higher interest rates, leaving only the small-savers to suffer the consequences of bail-ins. Add to this the big fish who have access to inside information or inside help from banks - the rich and the powerful and thus escape the haircut. The perennially tonsured common man does have cause for concern.

But that's not all, either. The bail-in clause significantly increases the perceived risk of holding FDs, which in turn erodes the depositor's confidence, leading them to flee from holding deposits in banks, preferring to hold cash (when the very objective of demonetisation was the exact opposite!). This was indeed observed in 2013 in Cyprus, when two large banks tanked, and pushed the bail-in buttons. As a consequence, the central bank had to close all banks for 10 days and stipulate several capital control measures, which seriously impaired the savings of the unsecured depositors, not unlike what we observed during the demonetisation exercise last year. Fixed deposits in Cyprus fell significantly, as households were seen to hoard more cash.

Such severe responses by the victims of the bail-ins invariably have a domino effect, and erode the trust of society in the banking sector at large, bringing about serious disruption in the depositors' behaviour as well as a nation's savings habits for a long time. Ours is too poor a country, the deposit insurance ceiling too low and alternative debt market instruments too illiquid for bail-ins that include FDs, unless the ceiling for deposit insurance is set at say Rs 25 lakh or higher, to accommodate the mid-level retirees who often park their PF and gratuity funds significantly in FDs, saving for their children's education and marriages.

The alternative would be to increase the deposit interest rates to account for the higher risk, which would have the effect of weakening the liquidity of the banks and increasing their cost of funds, neither of which can serve the cause of financial stability.

Plausible modifications

It is heartening to know that the government may be taking a relook at the bail-in clause. It is just as well, so that a demonetisation or GST-like messy situation is averted. Here are a few suggestions in case the bail-in clause is to be retained:

1. Significantly raise the deposit insurance ceiling; and/or

2. Spell out the pecking order for various creditors involved in bail-ins. In most banks, the ratio of Equity to Long Term Creditors to FDs to Loans & Advances are of the order of, say 1:1.5:10: 9, give or take. Let us assume that a bank is in serious trouble and stands to lose about one third of its advances, which is 3. The pecking order may state that first all shareholders may stand to lose their entire equity, namely 1. Next, the long-term creditors, including debenture holders, et al, would absorb the losses to the extent of 1.5. Thus, with 2.5 of the losses already absorbed by shareholders and long-term creditors, only the balance 0.5 would be absorbed by FD-holders, whose 10 may stand reduced to 9.5; and/or

3. Stipulate a ceiling stating, no more than, say, 15% of the total losses can ever be recovered from FD-holders above the deposit insurance ceiling; and/or

4. Banks may be required to offer FDs of varying risks (percentage of FDs at risk in case of bankruptcy) and appropriately higher returns in each risk-category. In such a case, the depositor would choose his risk-return trade-off up front, and the liquidity of the banks would not be affected significantly, as long as the lowest risk category pays out interest at current single rates applicable for FDs; and/or

5. Consecutive bail-ins must be spaced apart by at least 10 years in the life of any bank.

Needless to say, the suggestions are only indicative. Greater due diligence must be brought to bear on the matter before the clause is introduced, keeping in mind that worldwide, the implications of bail-ins have not yet been fully felt or understood. Better be slow than sorry.

(The writer is an academic and author)