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The right moves on deposit insurance - Outside View by S.S. TARAPORE

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The right moves on deposit insurance
Dec 26, 2014

A 'resolution corporation' for this purpose is a good idea, but it needs to be well funded

The Financial Sector Legislative Reforms Commission (FSLRC) has made a very important recommendation, namely, setting up a resolution corporation (RC).

The government, on September 30, 2014, set up a task force on a resolution corporation with M Damodaran as chairman. It can be said, without any hesitation, that merely the appointment of Damodaran, a veteran of many crises, instils a sense of confidence.

Wide sweep

The resolution corporation would resolve financial problems well before the stage of insolvency. This recommendation of the FSLRC is one which has the maximum financial ramifications and therefore deserves close attention. The resolution corporation will have all embracing powers over the financial sector.

In India we have a precedent of sorts in the form of the Board for Industrial and Financial Reconstruction (BIFR) which was eventually wound up.

The resolution corporation envisaged by the FSLRC is breathtaking in its vision, but to the point of bewilderment. If the RC can execute the vision, much of the woes of the financial sector would be resolved.

The central question is financing the RC and it is here that the Commission brings in the deposit insurance agency for banks within the ambit of the resolution corporation. It can be inferred that ultimately, insurance cover would be provided to non-bank financial units.

At present, deposit insurance is restricted to commercial and cooperative banks with a cross subsidisation of the cooperative banks by the commercial banks. Further, there have been years when the funds of the deposit insurance agency have not been sufficient to meet the liabilities and the Reserve Bank of India (RBI) has stepped in to fill the resources gap.

Grand Design

Once the resolution corporation is set up in this manner it will be impossible to restrict deposit insurance only to banks. While the grand design of a state of the art resolution corporation is commendable, the ambitious coverage envisaged by the FSLRC would be meaningful only if, simultaneously, there is an assured funding of the resolution corporation.

As it is, the funds of the present deposit insurance agency are insufficient and if both banks and non-banks are within the ambit of the same agency, there would be a clear shortage of funds. Lumping banks and non-banks into the same institution would be hazardous.

In the case of non-banks the insurance premium would need to be much higher and the experience has been that political economy considerations do not enable the prescription of a differential premium. Despite the Jagdish Capoor Committee having recommended differential premia for commercial and cooperative banks 15 years ago this could not be implemented. Covering both banks and non-banks within the resolution corporation could generate a huge financial burden on the government. Too often, ingenious solutions are sought to be implemented without assurance of funding.

Need for a different tack

Aping the US Resolution Trust for Indian financial companies would be drawing on a wrong model. In the US, the Resolution Trust picked up real estate housing at throwaway prices and as the cycle turned the Resolution Trust became self-financing. In India, well before the problems of financial companies come to the fore, the assets of the financial companies would only be empty shells.

There is need for a multi-track approach. The present deposit insurance agency for banks should be given powers akin to the US Federal Deposit Insurance Corporation (FDIC), which includes powers of regulating and supervising the deposits of banks.

It is pertinent to mention that the RBI banking regulators would not be prepared to part with regulating/supervising the deposit taking side of bank operations. Empowering the deposit insurance agency with some powers of regulation/supervision of banks should be a prerequisite before considering the setting up of a resolution corporation.

The world over, non-bank financial companies fail. If a resolution corporation is set up in India it should strictly cover only non-bank financial companies and there should be adequate financing for the resolution corporation to enable it to undertake remedial action before the net worth of these units become negative.

Effective performance

The FSLRC's dea of a resolution corporation is unexceptionable but banks and non-banks should not be covered by the same institution as the contagion can spread from non-banks to banks. Thus, any resolution activity for banks and non-banks should be kept separate and distinct.

The task force consists of eminent persons from the Indian financial sector. Under the leadership of Damodaran, crisis manager par excellence, the task force would do well to issue a caveat emptor as to the financial implications of the FSLRC proposal.

 Please Note: This article was first published in The Hindu Business Line on December 26, 2014.

This column, Maverick View is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Freepress Journal, is titled Common Voice.

Disclaimer:

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