Just as well govt scrapped FRDI Bill

The Bill, the finance ministry’s clarification said, had been introduced in the Lok Sabha on August 10, 2017.

Given the fears over the Financial Regulation and Deposit Insurance (FRDI) Bill of 2017, it is just as well that the government put out a statement last week saying it had ‘not taken any decision to reintroduce the FRDI Bill’. The Bill, the finance ministry’s clarification said, had been introduced in the Lok Sabha on August 10, 2017, and was withdrawn in August 2018 ‘for further comprehensive examination and reconsideration’.

At the heart of the controversy is the clause that said the regulator would use depositor funds—‘bail-in’—if the need arose. So, if a bank was, say, close to folding up, depositors’ money could also be used to help resurrect the bank along with, of course, the equity put in by the bank’s owners. And, given that most politicians are only concerned about the poor and the middle class—over 61% of bank deposits are of less than `1 lakh—they would think little of a ‘bail-in’ of higher-value deposits; while just 0.2% of bank deposits are of over `1 crore, this category of depositors account for a third of all bank deposits.

It is another matter, though, that even without the FRDI Bill, holders of AT-1 bonds in Yes Bank found their money disappear overnight; and in the case of the Punjab and Maharashtra Cooperative (PMC) Bank, depositors weren’t allowed to withdraw their deposits for a long time with RBI putting in restrictions to prevent a run on the bank.
Indeed, the point that few appreciate even today is that, even without the FRDI Bill, deposit-holders have remarkably little protection should a bank go bust; that there have been few bank failures is not really the issue since the law should provide for protecting depositors even in that eventuality.

Till recently, just Rs 1 lakh worth of deposits were insured so, in the event of a bank failure, depositors lost everything above this amount; this ceiling has been raised to Rs 5 lakh even though India’s GDP has risen 25 times since the amount was originally fixed in 1993. It is not clear why the limit wasn’t raised to several crore rupees or, in fact, to cover all bank deposits, never mind how large. This would reassure deposit-holders, and the insurance could easily have been paid for. While the Deposit Insurance and Credit Guarantee Corporation (DICGC), keep in mind, insures 92% of all deposit accounts, it insures less than 30% by value. Without bank deposits, there will be no banks, so all attempts have to be made to ensure depositors don’t get jittery; that is why FRDI was abandoned.

Ideally, if all deposits were to be insured, the banks could just charge a nominal amount from all depositors to pay the DICGC premium or, more realistically, offer clients a tiny amount less interest on their deposits. As it happens, DICGC is swimming in surpluses and earned Rs 12,043 crore in premium in FY19 and another Rs 7,245 crore as investment income on its Rs 87,995 crore of surpluses; the surpluses rose 2.5 times since FY14 as there have been no major bank failures for decades. Indeed, there were no net claims in FY19 as Rs 189 crore of earlier provisions for claims were reversed as compared to the Rs 37 crore of claims made in that year. An insurance company drowning in profits at a time when the market is woefully under-insured can hardly be a desirable state of affairs.

In which case, it is obvious the real problem was never the FRDI Bill, it was the low level of deposit insurance; the bail-in provisions do not apply to insured deposits. Had the insurance covered all deposits, no matter how large, who would protest against the Bill?

Indeed, the FRDI Bill raised the protection for depositors. Right now, if a bank goes bust, depositors are on a par with unsecured creditors. Section 80 of the FRDI, on the other hand, proposes that they be placed after employees and secured creditors, but before unsecured creditors and the state/central government and, of course, preference/equity shareholders. Ideally, they should have been on a par with secured creditors, but even without that, in the event of a bank being liquidated, the depositors were being moved up the pecking order so that they could get back their money faster.There are other clauses in the original Bill that protect depositors. Section 52(4) of the Bill, for instance, says the Resolution Corporation will decide which ‘liabilities or classes of liabilities’ are to be bailed-in; that is, taking over all uninsured deposits is not automatic, nor is it a given.

And with good reason since, if all bank deposits are bailed-in, big depositors will simply flee to really solid banks, or even out of the banking system; trying to save one bank, in the event, will lead to the entire banking system collapsing.Two questions arise. One, if big depositors have no protection right now, why aren’t they fleeing today? Two, if all deposits are insured, the banks and RBI will get complacent, and this will, in turn, lead to bank failure.
The reason why depositors aren’t fleeing is that there haven’t been any big bank failures, but were more PMCs or Yes Bank AT-1 episodes to happen, they will certainly get jittery.

As for RBI and banks getting complacent due to all deposits being insured, do owners, and building inspectors stop taking fire safety seriously just because the building is insured? The FRDI Bill, in fact, is quite clear that bail-ins can’t be done unilaterally by the regulator. Section 55(2) stipulates that no liabilities—such as bank deposits—can be extinguished unless there is a ‘provision to the effect that the parties to the contract agree to the liability being eligible for a bail-in’. So, this can be done in the case of, say, AT-1 bonds where a higher return is given and it is made clear—as it was—that they can be bailed in; investors are, then, taking an informed risk based on their understanding of whether the bank is likely to fail. If there was a furore over the Yes Bank AT-1 bonds despite this, it was because of allegations of misselling—investors claim they were not told they could be bailed-in—and because the bonds were written down even as equity holders were being protected; in any company failure, it is equity holders that take the first hit.

Given this, it is amazing that finance ministry politicians and bureaucrats were not able to explain how FRDI was a better deal for the depositor. This is so even in a situation where deposit insurance is not hiked. If it is hiked, and there is every reason to insure all deposits, no one could possibly have had any apprehensions about the Bill. If the ministry brings the Bill back, it will do well to do its homework if another fiasco is to be avoided.