Draft FRDI (Financial Resolution & Deposit Insurance) Bill 2017 is expected to provide a comprehensive framework to deal with bankruptcy situations in financial sector entities e.g. banks, NBFCs etc. The bill was approved by cabinet for introduction in the Parliament in June 2017. The bill is creating a lot of noise currently as it seems to include ‘bail-in’ clause for resolution of banks under bankruptcy proceeding. The issue is hot as numerous banks, especially public-sector banks, are under stress because of ‘assets gone sour’. The concern is genuine as more than 130 USD Billion assets are currently classified under Non Performing Assets in banking sector and this figure is very conservative as it excludes many assets which banks have been able to prevent from getting into NPA bucket by mere technicalities though knowing for sure that the asset is no longer performing. Considering that GoI has promised recapitalization of the tune of 36 USD Billion, question is how the deficit (++130- 36) is going to get funded or else the worst performing banks will be unable to provide loans and may disrupt the normal banking operations, as well.
Coming to ‘bail-in’, let us first explain the different between ‘bail-in’ and ‘bail-out’. Starting with the more common one, ‘bail-out’ refers to Government coming to the rescue of beleaguered banks/ financial institutions by providing the much-needed fund / capital to prevent the institutions from defaulting/ help revive. There are many instances of banks being bailed out by governments across the globe as any failure can have contagion effect and can ruin the financial system, cause trust deficit among customers and severely impact the economy. The fund for bail-out comes from budgetary allocation and hence is just pumping of tax-payer money to save these institutions. There is where the problem starts, as rising NPA is also linked to bad decision making of banks, investing in risky assets, corruption within the banking system, easy let out of corporate defaulters etc. The primary trigger though in general is economy downturn or some major external events. In popular imagination, therefore, it is using ‘hard earned money of tax paying individuals’ which is being used to bail-out ‘unscrupulous banks’ and ‘dodgy corporates’. Hence there is lot of genuine heart burn whenever such bail-outs happen. This is how Economists explains it “A bail-out is when outside investors rescue a borrower by injecting money to help service a debt. Bail-outs of failing banks in Greece, Portugal and Iceland were primarily financed by taxpayers.” Refer the featured image to understand the extent of tax payer money that has been used by USA in bailing its banks.
Bail-in provides an alternative narrative! Here there is bail-out by government but ailing bank’s own resources being used to bail it out. The resources under this can be owner capital, resources & surplus, borrowings of the bank and uninsured deposits. Economists explains a bail-in “forces the borrower’s creditors to bear some of the burden by having part of the debt they are owed written off”. With cost of government bail-outs increasing by the day, it is pertinent to ask private sector to foot the bill for bail-out and that’s where bail-in fits in.
To understand the bail-in concept, let us look at couple of examples where bail-in was exercise for banks/ financial institutions:
Bank of Cyprus (BOC) and LAIKI (Cyprus): 2013
- The estimated package of “bail-in” was EUR 7 billion at that time (2013)
- BOC was recapitalized while Laiki went through “sale of business tool” and was merged with BOC (Laiki was resolved with full contribution from shareholders, bondholders and uninsured depositors)
- “To recapitalize BoC, an estimated 37.5 % of BoC’s uninsured deposits were converted into full voting shares (at a rate of 40-50%) with additional equity contributions from legacy Laiki”
- “To prevent capital flight, the largest part of the remaining BoC uninsured deposits was temporarily frozen” which was later relaxed in a phased manner
- “The exact level of the bail-in (“haircut”), not determined until the end of June 2013, was set at 47.5 %”
- Overall status:
- The bail-in was considered successful though “In Cyprus the unexpected bail-in of depositors was perceived as neither fair nor moral, especially because certain households and businesses held simultaneously loans and deposits at different banks. Deposits could be bailed-in but not the loans, generating substantial frustration and damaging further the confidence towards the banking sector.”
- “Sound companies whose working capital was bailed-in were the biggest collateral damage from the bail-in.”
ANDELSKASSEN (Denmark): 2015
- The initial recovery plan for ANDELSKASSEN failed and hence was resolution was initiated by the financial stability company (Finansiel Stabilitet) under the new laws of BRRD (Banking Recovery and Resolution Directive)
- Owners and existing creditors were fully bailed-in (i.e. all contributed capital cancelled, write down of relevant capital instruments; existing owners lost all capital while creditors their outstanding) and ownership passed onto Finansiel Stabilitet under relevant BRRD laws
- Covered depositors (read insured upto EUR 100,000) remained fully protected
- A bridge bank (wholly owned by Danish resolution financing arrangement) was formed to provide capital to ANDELSKASSEN
- Ultimately it was decided to wind up the bank completely and surrender banking license. Approx. 2600 remaining customers, with deposit approx. DKK 132 million (USD 21 Million) was closed
The summary is that in case of bail-in, the banks existing owners, creditors will have to bear cost of resolution and in general that does not suffice leading to ‘haircut’ or full contribution of the uninsured depositors
The key challenge in implementing bail-in can be classified as follows:
- Creditors/ owners capital is generally found to be less than sufficient for bail-in (as banks are generally highly leveraged) and hence deposits will get impacted in-case of bankruptcy
- Potential loss in trust on banking system/ run on banks if deposits (uninsured) are found to be at risk of haircut or closure
- Deposit haircut can be hugely unpopular and difficult for a ‘vote bank’ led political system
- Expecting retail depositors to bail out a bank whose NPA primarily arose out of defaulting corporates
- Only deposits being bailed-in and not loans, increases hardships of individuals and can increase the NPA further which was seen in Cyprus case as well post bail-in
The key challenge in acceptance of ‘bail-in’ hence arises primarily from the expectation that such bail-in will also lead to closure/ haircut of deposits which primarily may be from retail customers
So; where are our banks standing if such a clause must be executed under current NPA levels? (this is more hypothetical as none of them are that close to become insolvent but risks remain especially for a few like IDBI, IOB, BOM)
To understand what may happen, we need to first understand the components of ‘Banking Liabilities’. If we look at the “Statements of Assets & Liabilities” for any banks (to be found in balance sheet/ quarterly statements/ annual reports); we find the following key components:
- Capital: Since banks are highly leveraged, this is the smallest amount
- Reserves & Surplus: Includes profit & loss account, general reserve (profit kept aside), share premium amount, statutory reserve etc.
- Deposits: Deposits of customers (retail & corporate including CASA, TD, FDs). This is the highest amount as this comes at a lower cost compared to external borrowings. 75-80% may be retail deposits
- Borrowings: From other banks, RBI, other Institutions & agencies, Upper & lower Tier 2 capital & innovative perpetual debts, Bonds & debenturs (excluding subordinated debt): for hdfc bank, 2nd, is highest, followed by 3rd & 4th which are nearly same & nearly 50% of 2nd
In terms of precedence of what can get dissolved/ forced contributed under bail-in, is probably will be capital, reserves & surplus followed by borrowings and then deposits.
In our subsequent analysis, we primarily focus on 2,3,4 as capital is very insignificant to cover such NPAs. For example, in case of IDBI, it can cover only 8% of its Net NPA.
Secondly, we will consider Net NPA (NNPA %) as that’s what is not already provisioned for (difference between Gross NPA and the Net NPA).
The below graph showcases the current NPA (Q2 FY18) status of key banks in descending trend. Remember, that NNPA is plotted on secondary axis. Also, as per RBI PCA guidelines, 6-9% is level 1 (Allahabad, PNB, P&SB, Andhra, Canara, Union, BOI) 9-12% is level 2 (United, Dena, Corp, UCO, CBI, OBC) and >=12% is level 3 breach (IDBI, IOB, BOM) for Net NPA%.
For the above 30 banks, gross NPA stood at 127 USD Billion, net NPA at 68.4 USD Billion while the GOI has promised 2.11 lakh cr (~32 USD Billion) capital infusion over next 2 years.
While that is large, it is not enough for banks to tide over NPA and still to be in a good position to lend & operate effectively
The below graph illustrates the bail-in scenario. The first line shows how much ‘Reserves & Surplus and Borrowing’ together covers NNPA while the 2nd line shows the current NNPA% followed by the 3rd line which highlights the NNPA% which if exceeded, will mean that any resolution mechanism must touch the uninsured deposit as well (because at that level the reserve & surplus + borrowings will not be sufficient enough to cover for the NNPA value).
There is no real threat of ‘deposits being touched’ at current financial conditions of the banks even for those who have breached, in-case the hypothetical insolvency situation arises for any of these banks
A few banks though are precariously close as highlighted by the dotted boxes
The below table provides the data corresponding to banks who have more than 5% Net NPA as of Q2 2018.
To conclude, bail-in is a known concept and have also been applied with varied success across globe for financial institutions. Generally, bail-in is not done alone but worked in conjunction with a ‘bail-out’ clause as well. Regulations across globe has started to incorporate ‘bail-in’ provision to ensure that cost of resolution is no longer only at cost of taxpayer but is also absorbed by creditors of the banks. In general, at the level of asset deterioration when insolvency gets kicked in, the existing capital, reserves & surplus & borrowings may not be enough for ‘bail-in’ and part of uninsured deposits can also be bailed-in. There is a corresponding contagion impact on customer confidence, trust on banks, run on banks and hence will remain very difficult to get implemented unless there is a very strong political will and acceptance across the ecosystem & its stakeholders. As of now, risks of seeing the above in India looks very less but in future we may look at a situation where bail-in & bail-out provisions are leveraged together.
Featured image is from a graph in https://financialservices.house.gov/blog/?postid=343018
Individual Banks quarterly financial statements