Financial Resolution and Deposit Insurance Bill 2017---and--- Prompt Corrective Action Framework

 Financial Resolution and Deposit Insurance Bill 2017---and--- Prompt Corrective Action Framework

This is in continuation to my earlier write-up on FRDI.

Financial Resolution and Deposit Insurance Bill 2017 (FRDI), proposed banking reform act, which creates lots of doubt in the mind of the public fueled by the opposition and media that the deposit in the banks will not be safe as the banks may be bail-in, in case of failure.  We have to realize that this is the redefined, legalized initiative of the present Prompt Corrective Action framework (PCA) a regulation formed by the RBI. This bill is necessary for the wake of financial crisis in 2007 caused by Layman Brothers failure and also ineffectiveness of the PCA framework of  RBI which could not control deterioration of Bank’s Health.

What is the salient feature of Prompt Corrective Action Framework?

A. Capital, asset quality, and profitability continue to be the key areas for monitoring in the revised framework.

B. Indicators to be tracked for Capital, asset quality, and profitability would be CRAR/ Common Equity Tier I ratio¹, Net NPA ratio and Return on Assets respectively.

C. Leverage would be monitored additionally as part of the PCA framework.

D. Breach of any risk threshold (as detailed under) would result in invocation of PCA..

*CCB would be 1.875% and 2.5% as on March 31, 2018 and March 31, 2019 respectively

i.        Breach of ‘Risk Threshold 3’ of CET1 by a bank would identify a bank as a likely candidate for resolution through tools like amalgamation, reconstruction, winding up, etc.

ii.        In the case of a default on the part of a bank in meeting the obligations to its depositors, possible resolution processes may be resorted to without reference to the PCA matrix.

E. The PCA framework would apply without exception to all banks operating in India including small banks and foreign banks operating through branches or subsidiaries based on breach of risk thresholds of identified indicators.

F. A bank will be placed under PCA framework based on the audited Annual Financial Results and the Supervisory Assessment made by RBI. However, RBI may impose PCA on any bank during the course of a year (including migration from one threshold to another) in case the circumstances so warrant.

Mandatory and discretionary actions
Specifications	Mandatory actions	Discretionary actions
Risk Threshold 1	Restriction on dividend distribution/remittance of profits. Promoters/owners/parent in the case of foreign banks to bring in capital	Common menu Special Supervisory Interactions Strategy related Governance-related Capital-related Credit risk related Market risk related HR related Profitability related Operations related Any other
Risk Threshold 2	In addition to mandatory actions of Threshold 1, Restriction on branch expansion; domestic and/or overseas Higher provisions as part of the coverage regime
Risk Threshold 3	In addition to mandatory actions of Threshold 1, Restriction on branch expansion; domestic and/or overseas Restriction on management compensation and directors’ fees, as applicable

Common menu for selection of discretionary corrective actions'

1. Special Supervisory interactions

·         Special Supervisory Monitoring Meetings (SSMMs) at quarterly or other identified frequency

·         Special inspections/targeted scrutiny of the bank

·         Special audit of the bank

2. Strategy related actions

RBI to advise the bank’s Board to:

• ·         Activate the Recovery Plan that has been duly approved by the supervisor
• ·         Undertake a detailed review of the business model in terms of sustainability of the business model, the profitability of business lines and activities, medium and long-term viability, balance sheet projections, etc.
• ·         Review short-term strategy focusing on addressing immediate concerns
• ·         Review medium-term business plans, identify achievable targets and set concrete milestones for progress and achievement
• ·         Review all business lines to identify scope for enhancement/ contraction
• ·         Undertake business process re-engineering as appropriate
• ·         Undertake to restructure of operations as appropriate

3. Governance-related actions

·         RBI to actively engage with the bank’s Board on various aspects as considered appropriate

·         RBI to recommend to owners (Government/ promoters/ parent of foreign bank branch) to bring in new management/ Board

·         RBI to remove managerial persons under Section 36AA of the BR Act 1949 as applicable

·         RBI to supersede the Board under Section 36ACA of the BR Act 1949/ recommend supersession of the Board as applicable

·         RBI to require bank to invoke claw back and malus clauses and other actions as available in regulatory guidelines, and impose other restrictions or conditions permissible under the BR Act, 1949

·         Impose restrictions on directors’ or management compensation, as applicable.

4. Capital-related actions

·         Detailed Board level review of capital planning

·         Submission of plans and proposals for raising additional capital

·         Requiring the bank to bolster reserves through retained profits

·         Restriction on investment in subsidiaries/associates

·         Restriction in expansion of high risk-weighted assets to conserve capital

·         Reduction in exposure to high-risk sectors to conserve capital

·         Restrictions on increasing stake in subsidiaries and other group companies

·          

·         5. Credit risk related actions

·         Preparation of time-bound plan and commitment for reduction of stock of NPAs

·         Preparation of and commitment to plan for containing generation of fresh NPAs

·         Strengthening of loan review mechanism

·         Restrictions on/ reduction in credit expansion for borrowers below certain rating grades

·         Reduction in risk assets

·         Restrictions on/ reduction in credit expansion to unrated borrowers

·         Reduction in unsecured exposures

·         Reduction in loan concentrations; in identified sectors, industries or borrowers

·         Sale of assets

·         Action plan for recovery of assets through identification of areas (geography wise, industry segment wise, borrower wise, etc.) and setting up of dedicated Recovery Task Forces, Adalats, etc.'

6. Market risk related actions

·         Restrictions on/reduction in borrowings from the inter-bank market

·         Restrictions on accessing/ renewing wholesale deposits/ costly deposits/ certificates of deposits

·         Restrictions on derivative activities, derivatives that permit collateral substitution

·         Restriction on excess maintenance of collateral held that could contractually be called any time by the counterparty

7. HR related actions

·         Restriction on staff expansion

·         Review of specialized training needs of existing staff

8. Profitability related actions

·         Restrictions on capital expenditure, other than for technological upgradation within Board approved limits

9. Operations related actions

·         Restrictions on branch expansion plans; domestic or overseas

·         Reduction in business at overseas branches/ subsidiaries/ in other entities

·         Restrictions on entering into new lines of business

·         Reduction in leverage through reduction in non-fund based business

·         Reduction in risky assets

·         Restrictions on non-credit asset creation

·         Restrictions in undertaking businesses as specified.

Any other specific action that RBI may deem fit considering specific circumstances of a bank

What is the change in the proposed bill?

 The bill provides resolution of the financial service provider in distress and deposit insurance. The Resolution Corporation to be formed by under the act will be provided i. deposit insurance, ii. Classify the service provider, iii. Undertake resolution in case of failure and iv. Investigate the activities of the service provider including search and seizure operations.

The financial service provider will be classified into six categories based on risk and viability viz. a. Low, b. Moderate c. Material d. imminent e. Critical. All the rating will be made public to understand the bank’s rating except Critical.

What is the benefit out of the new bill?

Although RBI has formulated the PCA framework in Mar 2001 and monitoring the banks on the parameters specified therein. In my view, RBI could not control effectively through PCA framework due to the reasons are known to them. They could not found out the concealment of Non-performing assets by the management in order to show a better balance sheet.  After all, damages are done, RBI has put many bankers under the scanner of PCA which includes Corporation Bank, Oriental Bank of Commerce, UCO Bank, Central Bank of India, IDBI Bank, Dena Bank, United Bank of India, Bank of Maharashtra and Bank of India. Had action initiated at the appropriate time this might not have happened.

Hence, this action of the forming a Resolution Corporation may help in controlling the bank effectively.  However, without the supervision rights, I have my own doubts about monitoring the rating of the banks by the Corporation. Hence, it is high time the government should segregate the supervision function of RBI into banking supervision body which should conduct Compliance AUDIT on the bank not only at the head office but also at major business branches to validate the rating parameters. Further, the supervisory body must have the right to punish the management of the erring bank. As per the regulation the rating of the bank will be made available to the public and hence there will be awareness among the public about the functioning of the bank. The action of winding up of the bank may be started early and done by the Resolution Corporation benefit the depositors.

All these points depend upon the management of the resolution corporation and it is effectiveness otherwise the bill will not have any benefit to the public. The establishment of resolution will reduce the time log in case of winding up of a bank as in normal course an official receiver is to be appointed by the Court who will collect all the due and distribute to the depositor.  The Bill also covers the insurance sector to protect the interest of the public as there is much private insurance player are in the field.

However, any bail-in process will result in systemic risk causing distrust on the banking sector hence, it should be avoided.  

WWW.RBI.ORG.IN 

Financial Resolution and Deposit Insurance Bill, 2017 (FRDI Bill)

Financial Resolution and Deposit Insurance Bill, 2017 (FRDI Bill)

First of all, Bank is also a company and controlled by various other acts such as Banking Regulation Act and regulated by RBI.  The financial sector is a backbone of the economy and trust should always be maintained for maintaining financial stability.  In India, RBI is maintaining the stability of the Indian Financial system and trust of common men that his deposit is safe with the Indian Banking System.

Deposit Insurance and Credit Guarantee Corporation:

The government has incorporated an insurance corporation in the name of Deposit Insurance and Credit Guarantee Corporation which guarantee the deposits made in the bank up to a limit of Rs. 1.00 Lacs and guarantees loans to the Small Scale Industries, small business finance and also loans under government sponsored schemes to the maximum of 75% of the loan outstanding subject to certain Conditions. Later the Credit Guarantee has withdrawn and the corporation remains as Deposit Insurance only.

Reserve Bank of India

Reserve Bank of India, is regulating the banking industry in India effectively and following the principle of “TOO BIG TO FAIL:”.  They merged a failed bank with another state-owned bank to maintain the depositors’ confidence.  When Global Trust Bank was failed, RBI force-merged Global Trust Bank with Oriental Bank of Commerce to prevent widespread losses to depositors It does not matter that the decision may have been motivated by a need to avoid a close scrutiny of how it was sleeping on its job. In fact, over the past several decades, the only payments made out of deposit insurance is on account of failed cooperative banks, which are under dual regulation (RBI and registrar of cooperatives) and completely controlled and manipulated by politicians across the spectrum.

What is the need for the Bill

The FRDI Bill is based on a 2014 working paper of RBI, in line with a global movement to create statutory structures to contain the contagion effect of the kind that shook the world in 2008 by the failure of large financial institutions. In November 2014, India, as part of the G20 nations, had agreed to create a legal structure which includes a ‘bail-in provision’ to recapitalize banks. But such a contingency is a matter of last resort. In fact, most global banks, including those in India (State Bank of India, ICICI Bank and Bank of Baroda had done this), have been asked to work on the concept of a ‘living will’, where they put in place a disaster management plan, if you will, on what is to be done in the event of a massive meltdown.  

 New regulation:

The government has introduced the Financial Resolution and Deposit Insurance Bill, 2017 (FRDI Bill) in parliament this June in order to provide to provide for the resolution of certain categories of financial service providers in distress; the deposit insurance to consumers of certain categories of financial services; designation of systemically important financial institutions; and establishment of resolution Corporation for protection of consumers of specified service providers and of public funds for ensuring the stability and resilience of the financial system and for matters connected therewith or incidental thereto.. The FRDI Bill aims to limit the use of public money to bail out distressed organizations in the event of a financial crisis, by providing a resolution framework to handle the failure of banks, insurance companies, and financial sector entities. It seeks to create a framework for resolving bankruptcy in financial firms (such as banks and insurance). This bill repeals the Deposit   Insurance and Credit Guarantee Corporation Act, 1962 and amends 12 other laws.

Resolution Corporation:

The central government will establish a Resolution Corporation. The corporation will have a Chairperson and its members will include representatives from the Finance Ministry, RBI, and SEBI, among others.

Functions of the Corporation will include:

 (i) Providing deposit insurance to banks (to repay deposits to consumers in case of failure),

 (ii) Classifying service providers (such as banks and insurance companies) based on their risk,

and (iii) undertaking resolution of service providers in case of failure.

It may also investigate the activities of service providers, or undertake search and seizure operations if provisions of the Bill are being contravened.

Risk based classification:

The Corporation shall, in consultation with the appropriate regulator, specify by regulations, objective criteria for classification of a specified service provider into any one of the following categories of risk to viability, namely:—

(a) Low, where the probability of failure of a specified service provider is

substantially below the acceptable probability of failure;

(b) Moderate, where the probability of failure of a specified service provider is marginally below or equal to acceptable probability of failure;

(c) Material, where the probability of failure of a specified service provider is marginally above acceptable probability of failure;

(d) Imminent, where the probability of failure of a specified service provider is substantially above the acceptable probability of failure;

(e) Critical, where the probability of failure of a specified service provider is substantially above the acceptable probability of failure, and the specified service provider is on the verge of failing to meet its obligations to its consumers:

While classifying the financial institutions into the above 5 categories The Corporation may specify different criteria for different categories of specified service provider but take into account the following attributes of a specific service provider

(a) Adequacy of capital, assets, and liability;

(b) Asset quality;

(c) Capability of management;

(d) Earnings sufficiency;

(e) Leverage ratio;

(f) Liquidity of the specified service provider;

(g) Sensitivity of the specified service provider to adverse market conditions;

(h) Compliance with applicable laws;

(i) Risk of failure of a holding company of a specified service provider or a connected body corporate in India or abroad; and

(j) Any other attributes as the Corporation deems necessary;

The above attributes are nothing but the enhanced CAMEL requirement prescribed by the regulator (RBI)

Action program of the Corporation

 If a service provider has been categorized under “CRITICAL” category, they need to submit a restoration plan to the regulator and resolution plan to the Corporation. The plan should contain the following points

1.   Details of assets and liabilities

2.   Steps to improve risk-based categorization,

3     Information necessary for resolution of the service provider

Based on the above details, The Corporation will undertake resolution of a service provider classified under Critical using either of the following options

ü  Transfer of its assets and liabilities to another person,

ü  Merger or acquisition,

ü  Liquidation, among others.

The management of the service provider will be taken over by the Corporation and it will be resolved in within a year of classifying under Critical

The liquidation and distribution of assets will require the approval of National Company Law Tribunal and the proceeds will be distributed on the following priority

Ø  Amount paid by Corporation as deposit insurance to insured depositors,

Ø  resolution costs,

Ø  workmen dues for 24 months and secured creditors

Ø  wages to employees for 12 months,

Ø  amount to uninsured depositors and other insurance-related amounts,

Ø  unsecured creditors,

Ø  government dues and remaining secured creditors (remaining debt  if they choose to enforce their collateral),

Ø  remaining debt and dues,

Ø  Shareholders.

The Bill did specifies penalties for offenses such as concealment of property, and destruction or falsification of evidence.

Special efforts of the bill:

 Bail-in clause in the FRDI Bill that allows the government to convert the depositors' money into equity in order to recapitalize and bail out banks that are facing bankruptcy. In case the Bank was liquated as per the corporation the uninsured depositor will be paid only after the secured creditors.  What is a bail-in? It is the opposite of bailout, where governments use taxpayers’ money to save large institutions. A bail-in gives statutory powers to a resolution authority to convert existing creditors (including depositors) into shareholders in order to recapitalize the bank. The FRDI Bill creates the statutory basis for such action by replacing the current deposit insurance guarantee corporation (or converting it) with a Resolution Corporation that will cover banks, financial institutions, and insurance companies. 

The FRDI Bill also envisages a ‘Corporation Insurance Fund’ that will insure a part of the deposits. The extent of deposits insured is likely to be substantially higher than Rs1 lakh insured today. These insured deposits will be out of the purview of appropriation for a ‘bail-in’. 

What is needed at this point?

1.   The FRDI bill should also include Cooperative Banks and non-Banking Financial Companies besides including the payment banks.

2.   The Bad loans are increased through because of the financing of infrastructure projects and greediness to achieve the targets. Loan drives in retail sector without proper infrastructure leads to increase in bad loans. The Banks fails to train the workforce in loan processing and maintenance of the loans leads to an improper assessment of loan and defective follow-up. This issue to be addressed first. Further, there is no Board level responsibility for bad loans of large caps and defectives policies; If a big loan fails the responsibility should be assigned to the top management as they have failed to take corrective actions. Government action of the mass write-off of loans pertaining to agriculture sector has instilled bad precedence in the minds of the agriculture borrowers that their loan will be written off if they do not pay. (During such mass write off  only affluent and bad borrowers were benefited instead of the needy one)

3.   Allowing a financial institution to fail will have a cascading effect on the economy. This is evident in 2007 crisis. Had the Lehman brothers bailed out in 2007, the whole financial crisis would have been averted. We have seen the worst part of non-bailout of Lehman Brothers. 

 Further, Indonesia is also the best example for bail-in of the banks. In 1999, Bank Rama was allowed to fail, it leads to financial crisis where the currency was taken to a spin. The exchange rate of the Indonesian Rupiah moved from less than 2000 per USD to 30000 with high volatility It stabiles to 10000 in 2007. The depositors also lost confidence in Banks and start in short terms tenure (one month) and renew on maturity. On the contrary, Malaysian Government has bail-out the banks and stabilized their financial system. We need to learn lessons from these incidents.

4.    Up to now Indian financial market is stable and won the trust of the depositor due to actions were taken by the Reserve bank in merging the failing bank with a strong Bank instead of bail-in.

5.   It appears some banks are now focusing on cross-selling instead of their core business as an incentive is attached to it for the Branch Manager to the top management. Hence, everyone was pressured to do cross-selling. Due to the pressure, lots of mis-selling happens. I am not against cross-selling but the incentive should be only for the person who is marketing the product i.e. the Branch Manager not everyone up above him.

6.   Banking Supervision should be delinked with RBI and formed a new corporation to monitor the banking system more efficiently. The Risk rating of the Banks may be handed over to the Bank Supervision body which will ensure rating really reflecting the health of the bank. We are also coming across incidents increasing bad loans/ provisions whenever the incumbency changes, indicate suppression of NPA to show a rosy picture. Such incident will be avoided if meaningful supervision is done by the regulator.

7.   BASEL III implementation is being postponed to 2019 in India although sufficient time for preparedness is allowed. It should be implemented in full so that the Banks will address the liquidity risk efficiently besides providing adequate capital to act as buffer for the expected/ unexpected loss.

Conclusion

The Bill is being revisited by the Finance Ministry and let us hopes the issues are addressed. 

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Based on the draft FRDI bill and also comments/ article/ views expressed on the bill over Internet (web pages)