The Financial Resolution and Deposit Insurance Bill, 2017 was introduced in Lok Sabha during Monsoon Session 2017. The Bill is currently being examined by a Joint Committee of the two Houses of Parliament. It seeks to establish a Resolution Corporation which will monitor the risk faced by financial firms such as banks and insurance companies, and resolve them in case of failure. For FAQs explaining the regulatory framework under the Bill, please see here.
Over the last few days, there has been some discussion around provisions of the Bill which allow for cancellation or writing down of liabilities of a financial firm (known as bail-in).[1],[2] There are concerns that these provisions may put depositors in an unfavourable position in case a bank fails. In this context, we explain the bail-in process below.
What is bail-in?
The Bill specifies various tools to resolve a failing financial firm which include transferring its assets and liabilities, merging it with another firm, or liquidating it. One of these methods allows for a financial firm on the verge of failure to be rescued by internally restructuring its debt. This method is known as bail-in.
Bail-in differs from a bail-out which involves funds being infused by external sources to resolve a firm. This includes a failing firm being rescued by the government.
How does it work?
Under bail-in, the Resolution Corporation can internally restructure the firm’s debt by: (i) cancelling liabilities that the firm owes to its creditors, or (ii) converting its liabilities into any other instrument (e.g., converting debt into equity), among others.[3]
Bail-in may be used in cases where it is necessary to continue the services of the firm, but the option of selling it is not feasible.[4] This method allows for losses to be absorbed and consequently enables the firm to carry on business for a reasonable time period while maintaining market confidence.3 The Bill allows the Resolution Corporation to either resolve a firm by only using bail-in, or use bail-in as part of a larger resolution scheme in combination with other resolution methods like a merger or acquisition.
Do the current laws in India allow for bail-in? What happens to bank deposits in case of failure?
Current laws governing resolution of financial firms do not contain provisions for a bail in. If a bank fails, it may either be merged with another bank or liquidated.
In case of bank deposits, amounts up to one lakh rupees are insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC). In the absence of the bank having sufficient resources to repay deposits above this amount, depositors will lose their money. The DICGC Act, 1961 originally insured deposits up to Rs 1,500 and permitted the DICGC to increase this amount with the approval of the central government. The current insured amount of one lakh rupees was fixed in May 1993.[5] The Bill has a similar provision which allows the Resolution Corporation to set the insured amount in consultation with the RBI.
Does the Bill specify safeguards for creditors, including depositors?
The Bill specifies that the power of the Corporation while using bail-in to resolve a firm will be limited. There are certain safeguards which seek to protect creditors and ensure continuity of critical functions of the firm. 
When resolving a firm through bail-in, the Corporation will have to ensure that none of the creditors (including bank depositors) receive less than what they would have been entitled to receive if the firm was to be liquidated.[6],[7]
Further, the Bill allows a liability to be cancelled or converted under bail-in only if the creditor has given his consent to do so in the contract governing such debt. The terms and conditions of bank deposits will determine whether the bail-in clause can be applied to them.
Do other countries contain similar provisions?
After the global financial crisis in 2008, several countries such as the US and those across Europe developed specialised resolution capabilities. This was aimed at preventing another crisis and sought to strengthen mechanisms for monitoring and resolving sick financial firms.
The Financial Stability Board, an international body comprising G20 countries (including India), recommended that countries should allow resolution of firms by bail-in under their jurisdiction. The European Union also issued a directive proposing a structure for member countries to follow while framing their respective resolution laws. This directive suggested that countries should include bail-in among their resolution tools. Countries such as UK and Germany have provided for bail-in under their laws. However, this method has rarely been used.7,[8] One of the rare instances was in 2013, when bail-in was used to resolve a bank in Cyprus.
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[1] ‘Modi government’s FRDI bill may take away all your hard-earned money’, India Today, December 5, 2017, http://indiatoday.intoday.in/story/frdi-bill-banking-reforms-modi-government-india-parliament/1/1103422.html.
[2] ‘Bail-in doubts — on financial resolution legislation’, The Hindu, December 5, 2017, http://www.thehindu.com/opinion/editorial/bail-in-doubts/article21261606.ece.
[3] Section 52, The Financial Resolution and Deposit Insurance Bill, 2017.
[4] Report of the Committee to Draft Code on Resolution of Financial Firms, September 2016, http://www.prsindia.org/uploads/media/Financial%20Resolution%20Bill,%202017/FRDI%20Bill%20Drafting%20Committee%20Report.pdf.
[5] The Deposit Insurance and Credit Guarantee Corporation Act, 1961, https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/dicgc_act.pdf. s
[6] Section 55, The Financial Resolution and Deposit Insurance Bill, 2017.
[7] The Bank of England’s approach to resolution, October 2014, Bank of England.
[8] Recovery and resolution, BaFin, Federal Financial Supervisory Authority of Germany, https://www.bafin.de/EN/Aufsicht/BankenFinanzdienstleister/Massnahmen/SanierungAbwicklung/sanierung_abwicklung_artikel_en.html.
Last month, Reserve Bank of India (RBI) released the report of the Expert Committee on Urban Co-operative Banks (Chair: Mr. N. S. Vishwanathan). In this blog, we discuss some broader issues with the functioning and regulation of urban co-operative banks (UCBs), and some of the suggestions to address these as highlighted by the committee in its report.
Need for Urban Co-operative Banks
The history of UCBs in India can be traced to the 19th century when such societies were set up drawing inspiration from the success of the co-operative movement in Britain and the co-operative credit movement in Germany. Urban co-operative credit societies, were organised on a community basis to meet the consumption-oriented credit needs of their members. UCBs are primary cooperative banks in urban and semi-urban areas. They are co-operative societies that undertake banking business. Co-operative banks accept deposits from the public and lend to their members. Co-operative banks are different from other co-operatives as they mobilise resources for lending and investment from the wider public rather than only their members.
Concerns regarding the professionalism of urban cooperative banks gave rise to the view that they should be better regulated. Large cooperative banks with paid-up share capital and reserves of one lakh rupees were brought under the scope of the Banking Regulation Act, 1949 with effect from March 1, 1966. Prior to this, such banks were regulated under the scope of state-specific cooperative laws. The revised framework brought them under the ambit of supervision of the RBI. Till 1996, these banks could lend money only for non-agricultural purposes. However, this distinction does not apply today.
The Expert Committee noted that UCBs play a key role in financial inclusion. It further observed that the focus area for UCBs has traditionally been communities and localities including workplace groups. They play an important role in the delivery of last-mile credit, even more so for those sections of the population who are not integrated into the mainstream banking framework. UCBs primarily lend to wage earners, small entrepreneurs, and businesses in urban and semi-urban areas. UCBs can be more responsive than formal banking channels to the needs of the local people.
Over the years, concerns have been raised about non-professional management in UCBs and that this can lead to weaker governance and risk management in these entities. RBI has also taken regulatory action on several UCBs. For instance, in September 2019, RBI placed Punjab and Maharashtra Co-operative Bank under restrictions on allegations of serious underreporting of non-performing assets. The bank could not grant loans, make investments or accept deposits without prior approval from RBI. While these restrictions were originally put in place for six months, the time frame was extended several times and has now been extended till December 31, 2021. In addition, low capital base, poor credit management and diversion of funds have also been issues in the sector.
Shrinking share in the banking sector
There were 1,539 UCBs in the country as of March 31, 2020, with deposits worth Rs 5,01,180 crore and advances worth Rs 3,05,370 crore. Even though 94% of the entities in the banking sector were UCBs their market share in the banking sector has been low and declining and stands at around 3%. UCBs accounted for 3.24% of the deposits and 2.69% of the advances in the banking sector. The Committee noted that state-of-the-art technology adopted by new players, such as small finance banks and fintech entities, along with commercial banks can disrupt the niche customer segment of the UCBs.
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Figure 1: Growth in deposits of UCBs (in Rs crore) |
Figure 2: Growth in advances of UCBs (in Rs crore) |
Burden of non-performing assets
UCBs had the highest net non-performing asset (NNPA) ratio (5.26%) and gross non-performing asset (GNPA) ratio (10.96%) across the banking sector as of March 2020. These levels correspond to around twice that of private sector banks, and around five times that of small finance banks. The Committee noted that, as of March 2020, UCBs have the lowest level of net interest margin (difference between interest earned and interest spent relative to total interest generating assets held by the bank) and negative return on assets and return on equity.
Figure 3: Asset quality across banks (in percentage)
Sources: Report of the Expert Committee on Urban Co-operative Banks; PRS.
Supervisory Action Framework (SAF): SAF envisages corrective action by UCB and/or supervisory action by RBI on breach of financial thresholds related to asset quality, profitability and level of capital as measured by Capital to Risk-weighted Asset Ratio (CRAR). The Committee recommended that SAF should consider only asset quality (based on net non-performing asset ratio) and CRAR with an emphasis on reducing the time spent by a UCB under SAF. The RBI should begin the mandatory resolution process including reconstruction or compulsory merger as soon as a UCB reaches the third stage under SAF (CRAR less than 4.5% and/or net non-performing asset ratio above 12%).
Constraints in raising capital
The Committee also observed that UCBs are constrained in raising capital which restricts their ability to expand the business. According to co-operative principles, share capital is to be issued and refunded only at face value. Thus, investment in UCBs is less attractive as it does not lead to an increase in its value. Also, the principle of one member, one vote means that an interested investor cannot acquire a controlling stake in UCBs. It was earlier recommended that UCBs should be allowed to issue fresh capital at a premium based on the net worth of the entity at the end of the preceding year.
Listing of securities: The Committee recommended making suitable amendments to the Banking Regulation Act, 1949 to enable RBI to notify certain securities issued by any co-operative bank or class of co-operative banks to be covered under the Securities Contracts (Regulation) Act, 1956 and the Securities and Exchange Board of India Act, 1992. This will enable their listing and trading on a recognised stock exchange. Until such amendments are made, the Committee recommended that banks can be allowed to have a system on their websites to buy/sell securities at book value subject to the condition that the bank should ensure that the prospective buyer is eligible to be admitted as a member.
Conflict between Banking Regulation Act, 1949 and co-operative laws
The fundamental difference between banking companies and co-operative banks is in the voting rights of shareholders. In banking companies, each share has a corresponding vote. But in the case of co-operative banks, each shareholder has only one vote irrespective of the number of shares held. Despite RBI being the regulator of the banking sector, the regulation of co-operative banks by RBI was restricted to functions related directly to banking. This gave rise to dual regulation with governance, audit, and winding-up related functions regulated by state governments and central government for single-state banks and multi-state banks, respectively.
2020 Amendments to the Banking Regulation Act: In September 2020, the Banking Regulation Act, 1949 was amended to increase RBI’s powers over the regulation of co-operative banks including qualifications of management of these banks and supersession of board of directors. The Committee noted that due to the amendment of the Act, certain conflicts have arisen with various co-operative laws. For instance, the Act allows co-operative banks to issue shares at a premium, but it is silent on their redemption. It noted that if any co-operative societies’ legislation provides for redemption of shares only at par, then, while a co-operative bank incorporated under that legislation can issue shares at a premium, it can redeem them only at par.
Note that on September 3, 2021, the Madhya Pradesh High Court stayed a circular released by the RBI on appointment of managing director/whole-time director in UCBs. The circular provided for eligibility and propriety criteria for the appointment of such personnel in UCBs. The petitioner, Mahanagar Nagrik Sahakari Bank Maryadit, argued that the service conditions of the managing director and chief executive officer of co-operative banks are governed by bye-laws framed under the M.P. State Cooperative Societies Act, 1960. The petition noted that co-operative as a subject falls under the state list and hence the power to legislate in the field of co-operative societies falls under the domain of the states and not the central government.
Umbrella Organisation
Over the years, several committees have looked at the feasibility to set up an Umbrella Organisation (UO) for UCBs. It is an apex body of federating UCBs. In 2011, an expert committee on licensing of new UCBs recommended that there should be two separate UOs for the sector. In June 2019, RBI granted an in-principle approval to National Federation of Urban Co-operative Banks and Credit Societies Ltd to set up a UO in the form of a non-deposit taking non-banking finance company. The UO is expected to provide information technology and financial support to its federating members along with value-added services linked to treasury, foreign exchange and international remittances. It is envisaged to provide scale through network to smaller UCBs. The report of the current Committee recommended that the minimum capital of the UO should be Rs 300 crore. Once stabilised, the UO can explore the possibility of becoming a universal bank. It can also take up the role of a self-regulatory organisation for its member UCBs. The Committee also suggested that the membership of the UO can be opened-up to both financial and non-financial co-operatives who can make contributions through share capital in the UO.
Comments on the report of the Expert Committee are invited until September 30, 2021.
