Banks with Liability Limited by Deposits – FRDI Act

The government’s proposal to introduce the FRDI Act (Financial Resolution and Deposit Insurance Act) by including the bail in clause has led to an apprehension about the status of the safety of depositors of the banks in Bharat in general and public sector banks in particular for their deposit sum exceeding Rs. 1 lakh, more so in the light of the purported fraud in Punjab National Bank that came to light recently.

Important Provisions of the Proposed FRDI Act

Clause 48. (1) of the proposed FRDI Act says-  The Corporation may resolve a specified service provider classified in the category of critical risk to viability (under section 45) through a scheme or a bail-in instrument, in such form and manner as may be specified by regulations made by it.

The bill futher says – a bail-in provision means any or a combination of the following, namely:—

(a) a provision cancelling a liability owed by a specified service provider;

(b) a provision modifying or changing the form of a liability owed by a specified service provider; and

(c) a provision that a contract or agreement under which a specified service provider has a liability shall have effect as if a specified right had been exercised under it.

Explanation.—In this sub-section, the expressions,—

(a) “cancelling a liability owed by the specified service provider” includes cancelling a contract under which the specified service provider has a liability;

(b) “modifying a liability owed by specified service provider” includes modifying the terms or the effect of the terms of a contract under which the specified service provider has a liability;

(c) “changing the form of a liability” includes—

(i) converting an instrument under which the specified service provider owes a liability from one form or class to another;

(ii) replacing such an instrument with another instrument of a different form or class;

(iii) creating a new security of any form or class in connection with the modification of such an instrument.

If one reads closely the clause 80 of the proposed FRDI Act one would notice that the uninsured bank depositors (ie., the depositors of more than Rs.1 lakh) rank next to the following categories of people in the event of liquidation of a bank – insured depositors ( i.e., depositors up to Rs. 1 lakh), staff salaries, secured creditors and wages due to employees other than workmen. Therefore, depositors having more than Rs. 1 lakh with a bank are treated as unsecured creditors.  

The above two clauses- 48 and 80 – have created ripples since the depositors may have to bear the brunt in the event of liquidation of a bank when the realisable value of the total assets are not adequate to cover the total deposit liabilities more so when the depositors are treated as unsecured creditors as mentioned above.

Extant Guidelines on Insurance of Bank Deposits

In this context if one analyses the extant guidelines that are applicable if a bank goes into liquidation it can be observed that a depositor will get back 100% of his amount up to and not exceeding Rs. 1 lakh as the same is covered under insurance with DICGC (Deposit Insurance and Credit Guarantee Corporation, a wholly owned subsidiary of RBI) by the banks. For any deposit in excess of Rs. 1 lakh the depositor will only get a pro-rata settlement in the event of a bank going into liquidation where the liquidated bank may not have sufficient funds to meet its deposit liabilities.

In other words, assuming a customer has Rs. 10 lakhs deposit and the bank goes into liquidation – if the liquidated and realized assets of the bank are 50% of its book value of its deposit liabilities (after excluding the amount of deposits up to Rs. 1 lakh per depositor that is fully insured) then the depositor will get Rs. 5.50 lakhs towards final settlement (i.e., Rs. 1 lakh plus 50%  of the balance deposit Rs. 9 lakhs).

The Finance minister has clarified saying, “The FRDI Bill does not propose in any way to limit the scope of powers for the government to extend financing and resolution support to banks, including public sector banks. The government’s implicit guarantee for public sector banks remains unaffected.”

Considering the history of Bharatiya banking since 1969 and post liberalization in particular there is a remote and unlikely possibility of a bank being allowed to go for liquidation putting the depositors’ interests into jeopardy. Nevertheless such a remote possibility cannot be ruled out if one looks at US economy which has faced subprime mortgage crisis in 2007 where several banks and financial institutions went into deep trouble and even the major insurance entity AIG (American International Group) had to be bailed out with a US $ 85 billion loan by US Federal Reserve to stave off bankruptcy!

The FRDI Bill only prepares a road map on how to move forward with the liquidation process of a bank giving better clarity by laying guidelines on the settlement of the dues of the depositors. However, there is a need to revisit the deposit insurance scheme that currently covers total risk protection only up to Rs. 1 lakh per depositor. There is also a need to promote a vibrant reinsurance model in order to avoid the US subprime mortgage type of situation in Bharat.

Data of Insurance of Bank Deposits as on 31 st March, 2017

Total amount of assessable deposits Rs. 103531 billion
Total number of accounts 1885 billion
Amount of protected deposits 30%
Amount of unprotected deposits 70%
Partly protected accounts  8%
Fully protected accounts 92%

(Source- https://www.dicgc.org.in/)

The author suggests the following mechanism for consideration by the regulatory authorities wherein the Indian banking sector can explore the possibility of providing hundred percent protection of the depositors’ funds by working out a deposit insurance cover as under.

  1. Continue the deposit insurance coverage up to Rs. 1 lakh per depositor.  
  2. On an ongoing basis the realizable value of the total assets of the banks to be computed at quarterly intervals.
  3. Any short fall between the total deposits of the banks (after excluding the value of deposits mentioned in point no.1 above) and realizable value of the total assets computed as above in point no .2 to be fully covered with the proposed corporation to be set up under the FRDI Bill by paying the premium on the same on quarterly basis.

Detailed working mechanism on the suggestion to provide hundred percent insurance cover on the deposits of the Banks

A. Banks liability to depositors= deposit amount plus interest accrued on those deposits.

B. Realizable value of the assets of the bank= cash and bank balance with RBI, balance with banks and money at call and short notice, investments, secured advances , fixed assets and other assets. (appropriate methodology may be adopted to compute the realizable value of the above mentioned assets)

C. Unsecured contingent liabilities.

D. Secured creditors.

E. Banks liability risk to depositors in the event of liquidation= A – fully insured or protected depositors up to Rs. 1 lakh.

F. Additional deposit insurance cover to be provided by the bank where the insurance premium to be paid on quarterly basis = for the difference amount where E > (B-C-D)  

The above mechanism will ensure 100 % risk protection of depositors’ money in the banks (i.e., all categories of banks) with an overall lesser deposit insurance premium burden to the banks. This will also enable the government to avoid extending an implicit guarantee for public sector banks for their liability to the depositors in the event of liquidation.

The government and RBI can think of introducing a new corporate entity under the nomenclature banking corporation with liability limited to deposits by making suitable amendments to the Banking regulation Act and the Companies Act. The broad definition of such banking corporation with liability limited to deposits can be in the lines of-“banking corporation with liability limited to deposits is one which will have a liability to meet its obligation towards repayment of its deposits along with accrued interest on such deposits as per the terms of the contract and the same crystallized or restricted to the amounts due under various deposits towards the principal plus accrued interest as on the date of liquidation of the banking corporation when such liquidation proceedings are initiated as per the FRDI Act.

The broad definition of such banking corporation with liability limited to deposits can be in the lines of-“banking corporation with liability limited to deposits is one which will have a liability to meet its obligation towards repayment of its deposits along with accrued interest on such deposits as per the terms of the contract and the same crystallized or restricted to the amounts due under various deposits towards the principal plus accrued interest as on the date of liquidation of the banking corporation when such liquidation proceedings are initiated as per the FRDI Act.”

Trust is the back bone of banking and it gets reflected in the safety of the depositors’ money and our banking regulator RBI and the government have so far lived up to the depositors’ expectations in this regard since 1969. Hope the government and the banking regulator RBI will take appropriate measures to ensure full protection of the depositors’ money which is the need of the hour and consider the suggestions mentioned above in this regard.

Featured Image source: indiatvnews.com


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About the Author

B.N.V. Parthasarathi
Ex Senior Banker, Management and Financial Consultant, Visiting faculty at premier B Schools and Universities. E mail- [email protected]