FRDI Bill and Protection to Depositors’ Money in Banks

Financial Resolution and Deposit Insurance (FRDI) Bill was tabled in Lok Sabha on 8th August 2017 and referred to a joint parliamentary committee represented by 30 members from both Lok Sabha and Rajya Sabha on 8th September, 2017. This joint parliamentary committee solicited views and suggestions from the public up to 29th September, 2017. The joint parliamentary committee is expected to give their report to the parliament shortly and it is understood that the bill is most likely to be presented in the ensuing winter session for approval.

The main objectives of this bill are-

  • To provide for the resolution of certain categories of financial service providers in distress;
  • To provide deposit insurance to consumers of certain categories of financial services;
  • To designate systemically important financial institutions; and
  • Establishment of a Resolution Corporation for protection of consumers of specified service providers and of public funds for ensuring the stability and resilience of the financial system.

The term specified service providers broadly include banks, insurance companies, NBFCs and systemically important financial institutions. The corporation proposed to be set up under this FRDI BILL will provide insurance to the depositors of the banks amongst other things. To this extent the proposed corporation will be rendering the functions of DICGC and therefore this bill proposes to repeal the Deposit Insurance and Credit Guarantee Corporation Act, 1961.

Additionally the proposed corporation will also handle the functions of resolution of the specified service providers (i.e., banks, insurance companies, NBFCs and systemically important financial institutions) when they are declared by the regulators as facing imminent or critical risk to viability of operations. Therefore, the proposed corporation will be performing a dual role – (i) providing deposit insurance and (ii) overseeing the liquidation and settlement of dues to the creditors of the specified service providers.

Liability of Corporation to insured depositors of insured service providers

Clause 29. (1) The Corporation shall, in consultation with the appropriate regulator, specify the total amount payable by the Corporation with respect to any one depositor, as to his deposit insured under this Act, in the same capacity and in the same right.

(2) The Corporation Insurance Fund shall be utilised by the Corporation—

(a) for payment of the specified amount or amount due, whichever is less, to a depositor of an insured service provider in respect of his deposit, in case of its liquidation;

A careful reading of the above provision leads to the conclusion that though the deposits of the public with the banks are insured with this proposed corporation, in the event of a claim caused by liquidation of the bank the corporation will only pay a certain amount which is in turn to be decided by the corporation in consultation with the regulators.

Clause 48. (1) 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 further 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.

A careful reading of the sentences in clauses 29 and 48 gives the inference that in the event of liquidation of a bank the corporation will decide in consultation with the regulators ( i.e., RBI in this case) a specified amount that is to be paid to the depositors. However the clause bail-in provides the corporation the options of canceling the liability of the bank to the depositors, reducing the liability by haircut or issuing a bond or any other form of instrument where the dues will be paid on a future date.

This clause has created ripples since the depositors will 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.

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 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 deposits 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).

Background on Liability of Banks to Depositors and Insurance of Bank Deposits and Advances

There were 361 private banks which “failed” across the country in the period from 1947 to 1955, resulted in depositors losing all their money as they were not offered any guarantee by their respective banks. Till 1969 SBI (then known by the name Imperial Bank of India) was the only bank that was not privately owned. It was observed that these private banks were only lending either to their own group entities to large industries. (Source-https://www.rbi.org.in/scripts/PublicationsView.aspx?id=10487).

In order to ensure that the bank credit reaches the priority sector comprising of agriculture, small industries, traders and entrepreneurs and to protect the interests of the depositors the Bharatiya government has nationalized 14 banks in 1969 followed by 6 more banks in 1980. Consequent to the nationalization these banks had removed the prefix and suffix to their names “The” and “Limited” respectively as they were totally owned by the government of Bharat thereby giving comfort to the depositors on total safety of their funds with the nationalized banks .

Insurance of Bank Deposits

Deposit Insurance Corporation (a wholly owned subsidiary of Government of Bharat) started extending insurance cover only for the bank deposits since 1961.The deposit insurance cover was made available originally only to the scheduled commercial banks (i.e., SBI and its subsidiaries, other commercial banks and branches of foreign banks operating in Bharat).

Since 1968 the deposit insurance cover was further extended to those cooperative banks that came under the ambit of RBI for liquidation, amalgamation or reconstruction. The deposit insurance cover was extended to RRBs in 1976. It may be repeated that the deposit insurance covers 100% up to Rs. 1 lakh per depositor in the event of liquidation of the bank.

Insurance of Bank Loans and Advances

RBI promoted Credit Guarantee Corporation of India (CGCI) in 1971 to provide guarantee cover to the loans and advances classified under priority sector (i.e., small scale industries and agriculture). In 1978 both DIC and CGCI were merged into DICGC. Consequent to this merger DICGC started extending its guarantee support to small scale industries from 1981 and from1989 onwards started extending this guarantee support to entire priority sector advances.

However, post liberalization banks started adhering to prudential norms for capital adequacy and started making provisioning of all advances and have therefore felt there was no need to continue availing the guarantee support from DICGC on loans and withdrew from the scheme of guarantee cover of DICGC.

In 2000 Government of Bharat and SIDBI have launched a credit guarantee fund scheme for micro and small enterprises covering loans and advances up to Rs. 100 lacs per borrower under a trust by name CGTMSE (Credit Guarantee Fund Trust for Micro and Small Enterprises) and the cap is increased to Rs. 200 lacs per borrower subsequently. Since 2003 banks have started insuring their agriculture loans with Agriculture Insurance Company of India Limited (owned by the public sector general insurance companies in Bharat).

Data of Insurance of Bank Deposits as on 31st 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/).

If one excludes the nationalized banks and the SBI (the seven subsidiaries of SBI since merged with SBI) collectively known as public sector banks, the rest of the banks comprising private banks and foreign banks having presence in Bharat are corporate entities and therefore have only limited liability.

However, as all these banks (i.e., both public sector banks and private and foreign banks) have covered their deposits under insurance with DICGC the depositors will get 100% risk protection up to and not exceeding Rs. 1 lakh in the event of liquidation of these banks.

A depositor having more than Rs. 1 lakh for the deposit amount beyond Rs. 1 lakh will receive on a pro-rata settlement as mentioned in the earlier paragraphs (when the realised value of the total assets is less than the total deposit liabilities amount) in the event of liquidation of the bank that happens to be a private sector bank or a foreign bank as they are corporate entities with limited liability. Whereas in the case of public sector banks (i.e., nationalized banks and SBI) since the government is a major share holder having more than 51% equity in the event of liquidation of these banks the depositors will not only get back 100% of their funds up to Rs. 1 lakh from DICGC but for any deposit amounts beyond Rs. 1 lakh there is full protection for the depositors’ funds in view of implicit guarantee by the government for public sector banks.

Post liberalization government has partially divested its share in the nationalized banks and SBI in favor of other institutional investors and others and these banks are listed on stock exchanges. However, the government continues to be major share holder having more than 51% stake in these nationalized banks and SBI (collectively known as public sector banks). The government has so far kept its commitment of infusing additional capital to these public sector banks when there is erosion of net-worth due to NPAs and operational losses in order to fulfill the criteria of capital adequacy under the prudential norms through the bailout route.

Now that the government is proposing to introduce the FRDI Bill by including the bail in clause as mentioned in the earlier paragraphs of this article, an ambiguity has arisen about the status of the safety of depositors of these public sector banks for their deposit sum exceeding Rs. 1 lakh. 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.”

Therefore, the depositors of public sector banks need not be apprehensive about the safety of their funds if these banks are facing liquidation (which is a very remote possibility) under the proposed FRDI Bill since the implicit guarantee of the government will make their deposits totally safe and secured irrespective of the amount whether it is up to Rs. 1 lakh or more than it.

The Finance Minister has additionally hinted in his above statement that the FRDI Bill does not in any way stop the government to extend financing and resolution support to all categories of banks not only public sector banks. In this context one may recall the merger of Global Trust Bank (GTB) which was a new generation private bank which came into existence post liberalization with Oriental Bank of Commerce a nationalized bank in 2004, where the depositors of GTB were fully protected and did not lose anything consequent to the merger.

Considering the history of banking in Bharat 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!

People in Bharat are by nature generally risk averse and prefer to keep their savings in the banks. 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. In this context let us recall the words of Joseph E. Stiglitz, Professor of Economics at Columbia University and Nobel Laureate, who while commenting on the US Subprime mortgage crisis said ‘If America had a central bank chief like Y.V. Reddy, the US economy would not have been in such a mess.’

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 reinsurance model in order to avoid the US subprime mortgage type of situation in Bharat. 

In this regard the author suggests the following mechanism to be adopted by the banks for consideration by the regulatory authorities.

  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.

The above mechanism will ensure 100 % risk protection of depositors’ money in the banks (ie., all category of 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. Hope the government will have a relook at the proposed FRDI Bill considering the above suggestion.

Featured image source: financialexpress.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]