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Using Deposits to Rescue Banks is a Bad Idea; It Needs to Be Nipped in the Bud

Dec 11, 2017

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I have been travelling for the past two weeks and a question that has been put to me, everywhere I have gone is: "will fixed deposits be used to rescue banks that are in trouble?"

People have been getting WhatsApp forwards essentially saying that the Modi government is planning to use their bank deposits to rescue all the banks that are in trouble. As is usually the case with WhatsApp, this is not true. The truth is a lot more nuanced.

Let's try and understand this in some detail.

Where did the idea of fixed deposits being used to rescue troubled banks come from?

The government had introduced The Financial Resolution and Deposit Insurance(FRDI) Bill, 2017, in August 2017. This Bill is currently being studied in detail by a Joint Committee of members belonging to the Lok Sabha as well as the Rajya Sabha.

The basic idea behind the FRDI Bill is essentially to set up a resolution corporation which will monitor the health of the financial firms like banks, insurance companies, mutual funds, etc., and in case of failure try and resolve them.

The Clause 52 of the FRDI Bill uses a term called "bail-in". This clause essentially empowers the Resolution Corporation "in consultation with the appropriate regulator, if it is satisfied that it necessary to bail-in a specified service provider to absorb the losses incurred, or reasonably expected to be incurred, by the specified service provider."

What does this mean in simple English? It basically means that financial firms or a bank on the verge of a failure can be rescued through a bail-in. Typically, the word bailout is used more often and refers to a situation where money is brought in from the outside to rescue a bank. In case of a bail-in, the rescue is carried out internally by restructuring the liabilities of the bank.

Given that banks pay an interest on their deposits, a deposit is a liability for any bank. The Clause 52 of FRDI essentially allows the resolution corporation to cancel a liability owed by a specified service provider or to modify or change the form of a liability owed by a specified service provider.

What does this mean in simple English? Clause 52 allows the resolution corporation to cancel the repayment of various kinds of deposits. It also allows it to convert deposits into long term bonds or equity for that matter. Haircuts can also be imposed on firms to which the bank owes money. A haircut basically refers to a situation where the borrower negotiates a fresh deal and does not payback the entire amount that it owes to the creditor.

But there are conditions to this...

The bail-in will not impact any liability owed by a specified service provider to the depositors to the extent such deposits are covered by deposit insurance. This basically means that the bail-in will impact only the amount of deposits above the insured amount. As of now, in case of bank deposits, an amount of up to Rs 1 lakh is insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC). This amount hasn't been revised since 1993.

Typically, anyone who has deposits in a bank tends to assume that they are 100 per cent guaranteed. But that is clearly not the case. Over the years, the government has prevented the depositors from taking a hit by merging any bank which is in trouble with another bigger bank.

So, to that extent the situation post FRDI Bill is passed, is not very different from the one that prevails currently. It's just that the government has come to the rescue every time a bank is in trouble and I don't see any reason for that to change, given the pressure on the government when such a situation arises and the risk of the amount of bad press it would generate, if any government allowed a bank to fail.

Over and above this, Clause 55 of the FRDI Bill essentially states that "no creditor of the specified service provider is left in a worse position as a result of application of any method of resolution, than such creditor would have been in the event of its liquidation."

This basically means that no depositors after the bail-in clause is implemented should get an amount of money which is lesser than what he would have got if the firm were to be liquidated and sold lock, stock and barrel.

While, this sounds very simple in theory, it will not be so straightforward to implement this clause.

So why is the government doing this?

In late 2008 and early 2009, governments and taxpayers all over the world bailed out a whole host of financial institutions which were deemed too big to fail. In the process, they ended up creating a huge moral hazard.

As Mohamed A El-Erian writes in The Only Game in Town: "[It] is the inclination to take more risk because of the perceived backing of an effective and decisive insurance mechanism."

If governments and taxpayers keep rescuing banks what is the signal they are sending out to bank managers and borrowers? That it is okay to lend money irresponsibly given that governments and taxpayers will inevitably come to their rescue.

In order to correct for this moral hazard, in November 2008, the G20, of which India is a member, expanded the Financial Stability Forum and created the Financial Stability Board. The Board came up with a proposal titled "Key Attributes of Effective Resolution Regimes for Financial Institutions". This proposal suggests to "carry out bail-in within resolution as a means to achieve or help achieve continuity of essential functions". India has endorsed this proposal. Hence, unlike what WhatsApp forwards have been claiming this proposal has been in the works for a while now.

But does this really prevent moral hazard?

A bulk of the banking sector in India is controlled by the government owned public sector banks. As of September 30, 2017, these banks had a bad loans rate of 12.6 per cent (for private banks it is at 4.3 per cent).

Bad loans are essentially loans in which the repayment from a borrower has been due for 90 days or more. The bad loans rate when it comes to lending to industry is even higher. In case of some banks it is close to 40 per cent.

This is primarily because banks over the years, under pressure from politicians and bureaucrats, lent a lot of money to crony capitalists, who either siphoned off this money or overborrowed and are now not in a position to repay. This is a risk that remains unless until the banking sector continues to primarily remain government owned in India.

Also, the rate of recovery of bad loans of banks in 2015-2016, stood at 10.3 per cent.

This does not inspire much confidence. In this scenario, having a clause which allows the resolution corporation to get depositors to pay for the losses that banks incur, is really not fair. The moral hazard does not really go away. The bankers, politicians and crony capitalists, can now look at bank deposits to rescue banks. As of now, the government and the taxpayers have kept rescuing public sector banks, by infusing more and more capital into them. Now the depositors can take over, if FRDI Bill becomes an Act.

It is worth pointing out here that the other G20 countries which have supported this proposal have some sort of a social security system in place, which India lacks. Given this, deposits are the major form of savings and earnings for India's senior citizens and clearly, they don't deserve to be a part of any such risk.

While, any government will think twice before using depositor money to rescue a bank, this is not an option that should be made available to governments or bureaucrats in India. It is a bad idea. It needs to be nipped in the bud.

These are my initial thoughts on the issue. Depending on how the situation evolves, I will continue to write on it.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. He is the author of the Easy Money trilogy. The books were bestsellers on Amazon. His latest book is India's Big Government - The Intrusive State and How It is Hurting Us.

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31 Responses to "Using Deposits to Rescue Banks is a Bad Idea; It Needs to Be Nipped in the Bud"

Kumar

Dec 18, 2017

When banks make profit the share holders are rewarded with dividends, bonus shares and appreciation in share value then why should depositors pay when the banks incurr losses on account of their inefficiency. A bank is a listed public company and it should be treated like other public companies. Govt should fix and punish people responsible for banks failure. No one is pointing when private sector banks do not have large and unmanageable Npas why only psu banks have huge npas and who is responsible for this state of affairs.

Like 

Ramakrishnan Gangadharan

Dec 13, 2017

Highly informative piece of a gem.

As it is still being drafted, it is too early to take any preventive judicial action. Further, I have
still hope that this will not go through both the houses of Parliament, as after the Gujarat elections, I feel there will defnitely a rethink in the BJP think tank's mindset that if they still
go ahead with this legislation, 2019 LS polls will prove to be a DISASTER.

Like (1)

Ashok Kothare

Dec 12, 2017

7400244655

You should have mentioned about the way BJP is supporting its Rajasabha member Mallya who is responsible for banks problems. I can understand why Mallya told Time Now reporter that he owes nobody anything! BJP is interested in duping sincere depositors to save its crony businessmen like Mallya. BJP is all out to destroy depositors for the benefit of their friends such as Mallya. Your essay is too much theoretical. You should also consider examples such as that of Mallya to explain the interior intentions of BJP to introduce such a draconian bill. You forgot to discuss about the role of RBI in this matter or is it that RBI has seized to function as a controlling body to save banks?

Like (1)

Pramod Khandelwal

Dec 12, 2017

You have explained the entire issue very lucidly and clearly. As rightly pointed out by you the economically vulnerable sections like senior citizens, middle and lower middle income sections who primarily depend on banks will be in potentially disastrous situation. While we have not been able to build social security system, the traditional family support system has vanished.

Like (1)

Ashok Desai

Dec 12, 2017

The deposit insurance, is scheme of protection for only the lower end of bank accounts. The Rs.1.00 lakh covers not only :

1. the deposit amount but also interest accrued,
2. the principal amount and
3. any amount lying in the bank account where the interest is regularly credited

Thus it is the total liability for that account. However in practise often the Insurance company interprets
any combination of personal joint accounts like ABC, ACB,and BCA as one.

This was experienced when quite a few co-op. banks were declared as failed in Gujrat around 2007/2008 by an RBI notification and accounts frozen. Subsequently it was allowed to be corrected and each combination of accounts clubbing was rescinded.

The insurance claim was paid on frozen liability amount as on the day of declaration issued by RBI and actual amount of compensation paid only after almost 2 years.

A similar situation occurred around the same time vis a vis Global Trust bank. There the principal share holder had better moral values and so arranged or manoeuvred a merger with Oriental Bank of Commerce. Now OBC needs help as part of the PSU banks?

This is a game of "Passing the Parcel" at best or robbing Peter to Pay Paul.

The persons who suffer the most in such cases are elderly citizens- or so called " Senior citizens". This class -with no social security, little help from distantly resident children and grandchildren behaving as visiting faculty, and equally elderly elderly support provider who themselves are senior or very senior citizens.

Added to this are the woes of inflation, value erosion of money or the Purchasing Power Parity fall of retirement corpus.

Silver lining to this is some administrators who come up with good schemes like SCSS 2004. In the 13 years this good scheme has been cannibalised, not updated and neglected, marauded and made very difficult to operate, made redundant by the systemic tempering for the worst.

Examples of marauding:

It was an insurance for the elderly and degenerating elderly populace past 60 years to the 90is - and beyond. Medical cover is zilch except for private sector- grand highway robbery. The scheme was constructed very thoughtfully by the then Finance secretary (must have had high moral fibre) with openness and power to modify for the welfare of the class to be respected and looked after.

In practice all modifications done have been of a detrimental nature. The total invest limit fixed then of Rs.15 lakhs not changed at all since 13 years. The interest rate offered then of 9.0% has seen it slide downwards.

Joint account with spouse only allowed, and not any elder citizen. etc.

Regards,

Ahade

Like (1)

R Varadarajan

Dec 12, 2017

I totally agree with you like most honest citizen in the country. Such step could be disastrous and detrimental to the senior citizen who have placed all their hard earned money in Bank on trust. While the depositors can never questions as to where the banks invest the money, so long as they generate surplus to pay the periodical interest to them, using the deposits to adjust the bad debts is rather horrible. It is a of BETRAYAL OF TRUST. Not only it will create chaos but would also create uncertainty in the minds of depositors and would move away from banks which could only cause further damage to the banking industry in the country

Like (1)

Varghese Mathew

Dec 12, 2017

I think it is time for you to start another campaign on the lines of the Political donation. Yes, everything must be done to stop something as absurd and preposterous like this.

Extremely well explained Vivek-ji.

Like (1)

Sridhar

Dec 12, 2017

Fully agree with you. My objections to this provisions are based on the fact that:
1) depositors do not share profits of the bank, why should they share the loss.
2) Govt is insisting that people should keep their money in the banks, then it should ensure that if there is a loss, it should step in to compensate, else allow people to keep their savings in cash,gold FX etc.

Sridhar

Like (1)

DAYANAND POOJARY, VARANGA

Dec 12, 2017

If any government wants to enact this act with such a clause first ensure guarantee it's citizens a social security otherwise don't dare to do so. We are not in a dictatorship state. else people will agitate to any extent.

Regards,
DAYANAND POOJARY, Varanga

Like (1)

VARGHESE VARKEY

Dec 12, 2017

9495234045 Yes, I agree with you. Depositors' money should be fully safe. Otherwise the country will go to dogs. Do everything to prevent the government from looting the depositors

Like (1)
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