BANKING

Engineering Banking Sector Recovery and Growth

A Vasudevan

T
The idea of “bail-in” in cases of serious banking he Financial Resolution and Deposit Insurance (FRDI)
instability has been widely discussed in India ever since Bill that was introduced in the Indian Parliament in
August 2017 has been referred to a select committee as
the introduction of the Financial Resolution and Deposit
on date. The committee has not given its report (till the end of
Insurance Bill. Given the large non-performing loans of January 2018). It is, however, expected that the bill with all or
public sector banks, the Government of India and the some of the committee’s inputs would be ready this year for
Reserve Bank of India as the regulatory authority have to Parliament to consider and pass. Now that bailout has been
announced, there is some waning of interest in the bill. The
quickly act to ensure that public confidence in the
Union Budget 2018–19 did not make any specific reference to
soundness of commercial banks is not breached. In this it. But it is important to recall the rationale, scope, and
context, three approaches are explored that could be intensity of the debate that followed the presentation of the
adopted either individually or in a variety of bill in Parliament in August 2017. This is because there are so
many unknowns in the current economic situation worldwide
combinations in different proportions essentially to
and uncertainty in the policy environment both in India and in
secure banking stability. The bail-in idea should not be most advanced economies.
considered except in extreme conditions of large The debate was specially focused on the idea of “bail-in,” a
financial stress. The idea could be tried even before the concept that was endorsed by the Group of 20 (G-20) coun-
tries, of which India is an important member. Bail-in is sup-
extreme situation arises with provision of incentives.
posed to be a significant way by which the financial stresses of
the banking system could be countered. The idea of bail-in
essentially means that the depositor would be able to get back
the deposit amount up to the insured deposit amount that
stands in India at `1,00,000 ever since the 1970s. Beyond the
insured amount of deposits, deposits of customers would be
converted into equity shares of the bank in question with
depositors’ consent. In other words, the depositor would not
only be a creditor to the bank but also a shareholder. The debt
claims on the bank would rise but since they are converted
into equity, the equity buffer of the bank would increase, and
perhaps would help maintain the regulatory capital adequacy
ratio. It could also help banks to undertake larger credit
disbursal in subsequent periods.
Bail-in as an idea is essentially a product of the global financial
crisis (GFC) of 2007–08. It is justified on a variety of grounds.
Since bank failures entail high costs on those who have to bear
the burden and entail critical externalities, public funding of
bailouts through the budgets is considered “moral hazard.”
Such publicly funded bailout, it is said, would destabilise public
finances, besides increasing sovereign debt. To avoid this prob-
lem, it is argued that bail-in could be used, even though it
would in effect be equivalent of “penalty.” In other words,
private penalty provides an insurance and it replaces public
This article is revised on the basis of excellent and incisive comments of subsidy through bailout (Avgouleas and Goodhart 2015).
the anonymous referee to whom the author expresses his profound thanks. Bail-in is now an accepted idea in many advanced econo-
A Vasudevan (vasudevanasuri@gmail.com) was Executive Director of mies, especially after Ben Bernanke, then Chairman of the
Reserve Bank of India and Special Adviser to the Governor, Central Federal Reserve System of the United States (US), opposed
Bank of Nigeria.
public bailout for entailing moral hazard in 2008.1 But in
138 MARCH 31, 2018 vol lIiI no 13 EPW Economic & Political Weekly
 BANKING

emerging and developing countries, this has not yet been fully Table 1 shows that during 2007–08 and 2016–17, real output
accepted. In these countries, there is always a large number of grew at an average of 7.35%. The low growth rate of 3.89% was
people who belong to lower income groups and maintain recorded in 2008–09, the year of the most severe form of GFC.
relatively small amounts of deposits with commercial banks, The highest growth rate of 10.26% was registered in 2010–11.
especially those that are owned by the federal government. In This outcome may be attributed to the high fiscal and monetary
the case of India, public sector banks (PSBs) have a predomi- stimulus that occurred in 2009–10 to avert the ill-effect of the
nant place in the financial system. They carry large number of loss of external demand. If the highest growth rate is consid-
deposit accounts. Their asset structure is largely loan driven ered as an outlier, then the average rate of the remaining nine
essentially because there is limited quantum of marketable years would be only 7.03%. The 7% growth seems to be a decent
and private corporate securities for investment. rate going by the international standards. Such a rate could ap-
PSBs also have a predominantly large amount of stressed proximate India’s potential growth, given the demographics
assets of banks, the “non-performing assets” (NPA s). If these that are increasingly digital-literate, and the fairly high invest-
banks do not turn around and recover their stressed assets ment rate. The one critical snag in attaining potential growth
quickly and to a substantial extent, there could be two prob- lies in the fact that productivity is not much in evidence partly
lems: one, domestic, and the other, international or external. because innovativeness and newer production methods and
The domestic problem is much graver than the external/ practices are not present in most production areas. Low productiv-
international one. It would result in a run on the banks if ity is not something unique for India, it is the case also in many
there is any whiff of a bail-in coming in without any definitive advanced economies where potential growth seems to have
plan for engineering recovery of lost or stressed assets. The declined in recent years, reducing thereby the output gap.
external problem would arise when capital inflows from Table 1: Major Macroeconomic Indicators (%)
abroad fall sharply, disrupting real activity as well as stock Years Growth Rate Inflation Rate Fiscal Deficit Current Account Saving Investment
to GDP Balance to GDP Rate Rate
market activity. The external rating agencies are also likely to
(1) (2) (3) (3)
pitch in giving low grades for foreign investment and for 2007–08 9.80 6.2 6.0 -1.3 36.8 38.1
those who would otherwise be interested in having transac- 2008–09 3.89 9.1 6.5 -2.3 32.0 34.3
tions with the country. 2009–10 8.48 12.4 4.8 -2.8 33.7 36.5
Concerned over the probability of occurrence of runs or 2010–11 10.26 10.4 5.9 -2.8 33.7 36.5
near-runs on banks, some government officials and ministers 2011–12 6.64 8.4 4.9 -4.2 34.6 39.0
tried to assuage the concerns of depositors by assuring that 2012–13 5.46 10.0 4.5 -4.8 33.9 38.7
financial resolution will be worked out without invoking the 2013–14 6.39 9.4 4.1 -1.7 32.1 33.8
bail-in provision. The Government of India has also provided 2014–15 7.51 5.8 3.9 -1.3 33.1 34.4
2015–16 8.01 4.9 3.5 (Prov) -1.1 32.3 33.3
substantial public funding and has shored up the financial con-
2016–17 7.10 4.5 3.2 (Est) -0.7
dition of PSBs, especially the weaker of them. On its part, the
(1) GDP growth is calculated on the basis of 2004–05 series for the years 2007–08 to 2011–12.
Reserve Bank of India (RBI) has placed a number of banks For subsequent years, the growth is calculated on the basis of 2011–12 series.
(2) The inflation rate is represented by the movements in the monthly averages of
under prompt correction action (PCA) programme.
consumer price indices (CPI). The rates from 2007–08 to 2011–12 are based on CPI for
Against this background, a few issues arise. They relate to industrial workers on the series generated with base 2001=100. For subsequent years, the
rate represents the change in the new CPI series with base 2012=100.
adequacy of deposit insurance, the sustainability of the cur-
(3) Saving and investment rates are derived on the series with bases same as those for the
rent unwillingness to make the use of bail-in idea, and the way calculation of real output growth.
Source: Handbook of Statistics on Indian Economy, 2016–17, Reserve Bank of India.
financial resolution would be undertaken without adversely
affecting the public confidence in the banking system, and Many observers consider that in 2017–18, India’s growth rate
without disrupting macroeconomic policy dynamics. Before would be 6.5%–6.7%. The International Monetary Fund’s
we proceed to discuss the issues, we shall provide a contextual (IMF) World Economic Outlook in January 2018 estimated
narrative of country’s economic situation essentially because India’s growth in 2018–19 would be 7.4%, based on the review
financial resolution and macroeconomic stability are not of major structural reforms undertaken in the financial sector,
mutually exclusive: they have to move together for any story of such as the introduction of goods and services tax (GST), and
development and stability to be considered sustainable. Since Insolvency and Bankruptcy Code (IBC), and on clear evidence
the idea of bail-in is of post-GFC origin, we shall look at the of the government’s commitment to fiscal prudence.
data from the time GFC erupted in 2007–08. With respect to inflation, the average for the 10-year period
works out to 8.11%, but in recent years it has been in the
The Context ballpark of 4%–5%. In 2017–18, inflation is expected to be
There is need to first capture India’s major macroeconomic within 4%. Fiscal deficit to GDP ratio has been continuously on
indicators. Table 1 provides information about real gross the decline since 2010–11 and is now likely to be pegged at 3%
domestic product (GDP) growth, inflation rate, fiscal deficit to as “normal” and “sustainable.” Total liabilities (both external
nominal GDP ratio and the ratio of external current account and internal debt) as proportion of GDP has been lower than
deficit to nominal GDP, along with information about saving 50% and the ratio has steadily declined since 2011–12. External
and investment rates. We have also provided a short sharp current account deficit to GDP ratio has been low especially
information about government debt in this paper. since 2013–14 partly owing to fall in not only prices of crude oil
Economic & Political Weekly EPW MARCH 31, 2018 vol lIiI no 13 139
BANKING

but also of other international commodities. Investment rate Let us now look at the composition of NPAs of PSBs emerging
has been over 33%, and the difference between it and the sav- on account of loans disbursed to the priority sector as distinct
ing rate has been in the neighbourhood of 1 percentage point. from the loans provided for non-priority sector and public
The indicators seem to suggest that macroeconomic stability sector. Year-wise details are given in Table 3. These NPAs seem
is, on the whole, reasonably satisfactory. The government and to be gross NPAs as percentage of loans as on 31 March. Total
the RBI would, therefore, need to ensure that policy mistakes amounts are however given in billion rupees.
are not made in the short to medium term, and undertake Table 3 shows that over 77% emanated from loans granted
reforms to develop the real and financial sector activity quickly to non-priority sector as of gross ones at end March 2017.
and in a simultaneous fashion. Besides, they need to be more NPA s of loans granted to priority sector, which includes
communicative of their policy intent and of their willingness agriculture, small and tiny industries, and disadvantaged
to strengthen the processes and institutions that are associated sections of population, amounted to 23% at end-March 2017.
with policymaking. As of 31 March 2008, loans to priority sector to the extent of
We have not viewed the critical financial sector develop- 61.5% turned out to be NPAs whereas loans to non-priority sector
ments and it is here India is faced with fragile financial system, formed 37%. Loans to public sector that turned out to be NPA s
especially the banking system. It is to this aspect that we shall was limited to 1%–2% between 2007–08 and 2016–17. Clearly
now pay attention. the sharp turnaround in the composition of NPA s as between
priority and non-priority sectors have begun to mount from
Indicators of Commercial Banking Sector Health 2009 onwards. This seems to be largely due to the enormous
Commercial banking sector forms the most dominant part of discretion that has been given to chief executive officers/
the total banking system that comprises cooperative banks, chairpersons of PSBs and their boards of directors with
regional rural banks, and local area banks as well. PSBs in par- regard to the amounts to be disbursed and the choice of the
ticular form over 70% of the total banking business in India. sectors for loan disbursal. It is also possible that diligence
All scheduled commercial banks (SCBs) have been advised by needed for loan processing and sanctions as well as surveil-
the RBI to have capital adequacy ratio of 9% even though it lance over the use of the disbursed loans to non-priority
could well be 8% if one were to go by Basel III norms. To get at sector were lax.
the required capital adequacy ratio, it is important to ensure that Table 3: Composition of Non-performing Assets
assets do not turn out to be non-performing. PSBs have been Years Priority Sector Non-priority Sector Public Sector Total Amount (` billion)

the main problem in that their NPAs have been substantial, 2008 61.48 37.10 1.42 404.56
2009 53.75 45.59 0.66 450.26
requiring among others, capital infusion by the government.
2010 50.89 48.58 0.52 599.24
2011 53.82 45.85 0.32 746.64
Non-performing Assets
2012 47.57 50.17 2.27 1,172.62
Table 2 provides an idea of NPAs of all scheduled banks and 2013 40.91 58.39 0.70 1,644.61
PSBs from 2007–08 to 2016–17 in terms of percentage of gross/ 2014 35.16 64.79 0.06 2,272.64
net advances. 2015 34.69 65.21 0.09 2,784.68
Table 2 shows that from 2.3% of gross advances, SCBs’ gross 2016 23.30 76.70 0.64 5,399.57
NPAs have gone up to 9.3% in 2016–17 and further to 13% by 2017 23.50 76.50 2.26 6,847.32
September 2017 as per media reports. The gross NPAs of PSBs Source: Statistical Tables Relating to Banks in India, 2016–17, Reserve Bank of India.

rose from 2.2% in 2007–08 to 9.3% by 2015–16 and have gone What is also important to note is that where the amounts
up further to over 13% by September 2017. In terms of net NPAs, provided for financial derivatives, which form part of off-balance
the situation had been still worse. The sudden jump in NPAs from sheet items, are not repaid, they would be included under NPAs.
2014–15 seems to be mainly on account of the asset quality review Data on derivatives are available for foreign exchange con-
introduced by the RBI, although analytically speaking, it is in- tracts, of which forward foreign exchange contracts are very
congruous to argue that such quality review was not under- large, futures and swaps where cross currency interest rate
taken in the supervisory reports for the years preceding 2014–15. swaps are dominant and interest rate related contracts that
Table 2: Non-performing Assets of Commercial Banks are largely of single currency interest rate swaps right from
Years Gross NPAs of All SCBs Net NPAs of All SCBs Gross NPAs of PSBs Net NPAs of PSBs 2012 onwards. They are reported by RBI. Commercial banks
2007–08 2.3 1.0 2.2 1.0 provide funds largely for foreign exchange contracts. Foreign
2008–09 2.3 1.1 2.0 0.9 banks and private sector banks finance foreign exchange
2009–10 2.4 1.1 2.2 1.1 contracts in overwhelmingly large amounts compared with
2010–11 2.5 1.1 2.4 1.2 the funds provided by PSBs.
2011–12 3.1 1.3 3.3 1.5
Insofar as bank deposits are concerned, the household sector
2012–13 3.2 1.7 3.6 2.0
held over 68% of deposits in PSBs and about 52% in private sector
2013–14 3.8 2.1 4.4 2.6
banks. Household sector deposits form about 63% of deposits in
2014–15 4.3 2.4 5.0 2.9
2015–16 7.5 4.4 9.3 5.7
all scheduled banks. The remaining is held by (i) government
2016–17 9.3 5.3 sector (about 14%); (ii) non-financial private corporate sector
Source: Handbook of Statistics on Indian Economy, 2016–17, Reserve Bank of India. (about 10%); (iii) financial sector (about 6%); and (iv) foreign
140 MARCH 31, 2018 vol lIiI no 13 EPW Economic & Political Weekly
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sector (about 7%). Data on term deposits with SCBs reveal in- One could also consider combinations of the above three
teresting facts. Of the accounts held by individuals, 99.1% approaches in different proportions.
were in terms of size of deposits of less than `1.5 million. More
than two-thirds of term deposit accounts held by individuals are Strong Recovery and Growth Plans
of less than `1,00,000—the limit for deposit insurance as well. Of the three approaches, the first can turn out to be effective
And the amounts held by such a large number of account hold- only if plans are bank-specific and correctly understood by
ers would form about 13% of total individual holdings of term bank employees who are empowered to process loan applica-
deposits. Term deposits over `1.5 million are held by less than tions or/and grant loans, and to keep a watch on the perfor-
1% of individuals, but they form about 28.5% of total amount mance indicators of each of the loan accounts. The internal
of term deposits. Term de- Table 4: Insured Deposits to Assessable control mechanisms, including internal audit as well as
posits in the size of `0.1 mil- Deposits accountability principles, should be drawn, with discretion
Years All Scheduled PSBs Cooperative
lion– `1.5 million are 31.5% Banks Banks having no scope to play.
of the number of accounts, 2007–08 60.5 73.3 65.4 In the past, whenever the subject of structural reforms was
and 57.2% in terms of the to- 2008–09 56.2 66.3 67.3 mooted, references were often made to strategic plans for im-
tal amount of term deposits. 2009–10 36.7 39.4 62.9 proving the performance of banks but such plans hardly
Quite a good proportion 2010–11 35.0 35.9 64.0 worked effectively either because they were not implemented
of deposits fall outside the 2011–12 33.0 32.5 62.4 in letter and spirit or because there is no incentive for the bank
ambit of insurable deposits. 2012–13 32.6 32.5 56.9 staff to implement the plans. It is, therefore, necessary to have
Table 4 provides some inter- 2013–14 31.2 30.2 58.2
in place processes of selection of persons who could deliver the
2014–15 30.8 31.4 54.5
esting facts about the evolu- goals of the plans within a specified period. Besides, there is a
2015–16 30.1 31.4 51.2
tion of insured deposits as a 2016–17 29.5 31.5 48.1
need for laying down targets for substantial recovery of loans
percentage of total assessa- Source: Statistical Tables Relating to Banks in and for fixing accountability on the management teams of
ble deposits. India, 2016–17, Reserve Bank of India. banks. The government may consider appointing within the
next three to four months a three-person evaluation commit-
Main Issues tee of outsiders to critically examine the progress made
From the above description of the macroeconomic situation towards recovery and report it on banks’ bulletin boards for
and the state of banking in India, one would deduce that customers to see and to the specified government authorities.
macroeconomic stability can turn out to be a mirage if the The bank-specific plans need to be devised by three parties
banking system is not placed under a heavy roller of reforms. sitting together: the management of the bank in question, the
Most of the needed reforms fall under the generic label of Government of India and the RBI. The inclusion of RBI in this
structural reforms. But no reform can be undertaken without workout is based on the logic that it has to bear some responsi-
first tackling NPAs of PSBs, a point that needs to be emphasised bility for having so many PSBs in the red with large NPAs. It is
at this point in time. For, reduction of NPAs to a level that can one thing to say that the asset quality review threw up the
be easily manageable is critical for instilling confidence in the statistics about NPAs in proper dimensions; it is another thing
sustainability of the banking system, for reducing disruption to place under the carpet questions about the effectiveness of
in the financing of real sector activities and for containing any the extant supervisory practices and methods before the asset
possibility of macroeconomic instability. quality review was introduced. The fact is that both offline
In this context, the central government could adopt three and online supervisory practices and methods could not stem
approaches. the accumulation of NPAs. It is difficult to comprehend the
(i) Prepare what may be called here for want of a better term, rationale of placing many PSBs under prompt corrective action
strong recovery and growth plans for each of the PSBs with in- programmes notwithstanding the rule-based supervisory
dicative targets for each year for the following three years. frame of RBI.
This could pave way for pursuing structural reforms in the The RBI has to also undertake another responsibility as one
short to medium term. that has now clearly recognised the importance of ensuring
(ii) Recapitalise banks in full or in such a manner that NPAs that financial stability is secure at all times. It has to exert ac-
are sharply reduced. This approach is the typical public bail- tively its dual role as a supervisor and a regulator of all banks,
out. It is possible to limit direct budgetary support to recapi- whether they are in the private sector or in the public sector. It
talisation and infuse capital through issuance of recapitalisa- has also a distinct risk management unit. Given the fact that
tion bonds and through market borrowing. This has implica- PSBs are burdened with large and growing NPAs, it would be
tions for fiscal dynamics. It is best to have bailout along with useful to utilise the expertise in the RBI in the area of risk man-
the implementation of recovery and growth plans so that agement for strengthening risk management in PSBs.
banks would not accumulate further NPAs or face NPA problem To be more specific, the RBI could appoint a team of two or
again in near future. three senior officers who are well-versed in risk management
(iii) Utilise the possibility of “bail-in” to an extent that (from the risk management unit as well as from its regulatory
customer and public confidence in commercial banks is wing) for one or two of the PSBs for a medium-term period.
not eroded. The report of the risk management team appointed for the
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purpose may identify the weaknesses and strengths in the has been sharp. The expected improvement in the economic
concerned bank’s internal audit and other control units. The performance of advanced economies may not materialise if
report would help the management of the concerned bank. It stock markets in US, as some observers fear, collapse or if
would be most useful if after proper vetting, the report is economic activity does not pick up owing to widely expected
placed on the website of the Indian Bank Association periodi- monetary tightening. Larry Summers, former Treasury Secre-
cally. The website could also provide space for the concerned tary, felt that the risk of policy mistakes in the US is seemingly
bank’s action-taken note. This approach would be a transpar- high and could lead to another protracted and deeper reces-
ent practice that would help promote not only accountability sion with severe global consequences. In his view, the US econ-
but also credibility to boost public’s confidence in the sound- omy could fall into recession in the next three years (Summers
ness of banks in general and PSBs in particular. 2017). The uncertainty in this regard cannot be downplayed at
Bank-specific reforms for fostering recovery and growth of this juncture especially given the unknowns about the out-
banks are really a part of operational reforms and need to be come of the Brexit and the impact of the US tax bill.
distinguished from systemic structural reforms for medium-
term banking stability and improved bank performance. In the Recapitalisation of Banks
latter area, a number of questions are often posed by many This approach cannot be avoided in emerging and developing
analysts. For instance, is it necessary to divest government’s economies where the financial sector is not well developed
shares in PSBs at this point of time? Should the government and where avenues for saving in the form of financial assets
lose management control and reduce its stakes to less than are not many. Public bailout could, under a fiscal frame of
50% of total equity capital? Should there be foreign invest- limited revenue enhancement and the absence of space for
ment in PSBs? Besides, should the number of PSBs be reduced cutting down public expenditures, lead to enlargement of
to a manageable number with mergers so that each of the fiscal deficit whose monetary effects could be significant.
structured entities would become relatively more capitalised? Besides, bailout could entail an opportunity cost in that ex-
These are important questions. There is near consensus that penditures for other items such as Table 5: Government’s Capital
PSBs should divest gradually. There is also a view that PSBs infrastructure and social welfare Infusion into Scheduled
Commercial Banks (` crore)
should be reduced in numbers. But no one knows the number programmes may be sacrificed.
2007–08 10,000
of PSBs that one could consider as ideal or optimal for banking The public bailout has been
2008–09 1,900
development. Nor is it well known as to how much of divest- substantial since about the sec-
2009–10 1,200
ment should take place say in the next three years. One thing ond half of the 1980s. Between
2010–11 20,117
however seems to be certain: a wholesale privatisation is not 1985–86 and 2006–07, total capi- 2011–12 12,000
and would not be on the cards in the medium term. tal infusion in PSBs by the federal 2012–13 12,517
On foreign investments in PSBs, the seemingly reasonable government amounted to `22,092 2013–14 14,000
view is that so long as the regulatory framework is sound and crore, of which `10,063 crore were 2014–15 6,990
well implemented, foreign investments could be allowed. But provided in just two years, 1993–94 2015–16 25,000
none of these could be undertaken in a hurry without integrating and 1994–95. From 2007–08 on- 2016–17 25,000
ideas on them with bank-specific plans for recovery and growth. wards, there was capital infusion 2017–18 2,11,000
Source: Bandyopadhyay and
Will the recovery plans work if there is no commitment on every year. The details are given Bhattacharya (2018).
the part of the banking bureaucracy and the government’s in Table 5.
own surveillance is not up to the task? Commitment is critical The huge capital infusion announced in the media on 25
even where ideas on corporate governance of boards of banks, January 2018 is essentially tied to strict terms for issuing re-
many of which have been elaborated upon in P J Nayak Com- capitalisation bonds to PSBs mainly to provide for additional
mittee report entitled, the Report of the Committee to Review credit offtake capacity of PSBs. And PSBs will be capitalised to
Governance of Boards of Banks in India, brought out in May maintain regulatory capital requirement, according to media
2014 are generally agreed to. No course of action would work reports. This infusion will help PSBs under prompt correction
if there is no commitment to the idea of good governance and action programme fulfil the regulator’s requirement. This
for its implementation. Penal actions may not work on errant amount will form about 1.3% of India’s GDP.
banks. Even mergers of errant banks with relatively sound Public bailouts without support of proper plans for loan
bank or banks may not work. It is also doubtful if corporate recoveries and for eliminating frictions for credit disbursal
governance will show radical departure from the existing situ- would be unproductive. This year, however, there is a realisa-
ation even with a system of incentives for large-sized and rela- tion that the bailout should be accompanied by plans for
tively sound banks. recovery and growth of banks, and to that extent, there is
It is however possible that even where the banking bureau- hope that there would be a quick financial turnaround of banks.
cracy is committed, and is generally guided by the generally
accepted principles of corporate governance, external devel- Possibility of ‘Bail-in’
opments and/or sudden/unexpected deterioration in the macro- Normally simultaneous pursuit of the first and second
economic situation could work as major constraints. Already approaches should work. But it would be foolhardy to rely only
there are signs that the surge in international crude oil prices on these two approaches, given the uncertainties in the
142 MARCH 31, 2018 vol lIiI no 13 EPW Economic & Political Weekly
 BANKING

working of most economies of the world. Should one then con- would be unique in that they would carry a fixed coupon rate
sider the third approach? This is a highly controversial and guaranteed by the government and would be tax-exempt.
non-populist approach. And resistance to bail-in is substantial There may not be any international comparatives with such
and could also result in strong political upheaval. bonds because these bonds are circumstance-specific. The
Bail-in as an idea has support of some Indian economists. coupon rate on the bonds should be equivalent to bonds of
Ajay Shah observed in one of his recent articles on the FRDI Bill: similar maturity and could be offered to the depositors who
Bail-in may appear draconian, but is sometimes necessary. The Bill
are willing to offer deposits beyond a certain amount in writ-
features adequate safeguards: Regulations made in advance will spec- ing to the concerned banks. The interest accrued on such
ify which classes of liabilities can be bailed in; … bail-in power must bonds should be credited half yearly into the saving bank de-
respect the hierarchy of claims; only those liabilities can be cancelled posits of bondholder-depositors. Besides, and this is very im-
where the instrument creating it contains a provision stating that the portant, such interest income should be tax-exempt. The case
parties agree to the liability being eligible for a bail-in; no creditor of relief bonds may be cited as one that elicited high positive
(including depositor) must be left in a worse position than they would
response because of tax exemption and attractive interest rate.
have been in the event of its liquidation, and if this does not happen,
they would be given compensation by the RC [Resolution Corpora-
(iv) FRV bonds could be issued in favour of one person. A ben-
tion]; the bail-in powers can only be used by the RC in consultation eficiary could be named in each bond.
with the RBI; the RC is required to forward the bail-in instrument to (v) FRV bonds cannot be collateralised. They should be held till
the Central government together with a report with explanation about maturity or till such time the primary bond holder is alive.
the reasons why bail-in was required, and a copy of this report is to be Assuming that where the bank in question implements its
laid before Parliament. (Shah 2017) strategic plan forcefully and the bank becomes viable, it could
There is a different viewpoint by another economist, exercise the option of buying back the bonds even before the
Soumya Kanti Ghosh who spoke of an incentive approach that date of maturity or extending the maturity period by one or
could be tried for bail-in, a point on which this author made a two years after getting consent from the bondholder.
contribution that was acknowledged by Ghosh (2017). Here I There is no reason to think that depositors cannot work out
shall explain in full the incentive approach that needs to be their portfolios in a manner that a portion of their total depos-
adopted in case bail-in cannot be avoided. This needs to be its would not consist of FRV bonds. This approach would be far
supported by a prior action to raise the cap on the deposit superior to the idea of bestowing “shares” to depositors
insurance amount fixed in the 1970s from the paltry `1 lakh to through the conventional bail-in argument because the incen-
`10 lakh per deposit account holder. It would be ridiculous to tive for depositors to hold shares of problem banks, at least in
say that a person who, say, has deposits worth `50 lakh is com- the short period of a year or so, may not be sufficiently attrac-
pensated with `1 lakh, as at present, in the event of severe tive for a large number of depositors.
bank stress. Deposit insurance premium could be adjusted in a
manner that all banks improve the insured deposits to assess- Final Pointers
able deposits from the present levels by at least 10 percentage The arguments made here would apply not only for PSBs that
points within a matter of three years. are stressed but also for other banks that are faced with the
It is necessary to evolve an incentive approach to elicit challenge of addressing the problem of NPAs. Plans for recovery
depositor cooperation and assistance. There is a class of de- and growth should be strongly supported by sound risk man-
positors, one tends to believe, which will be willing to respond agement practices in each bank with the RBI pitching in with its
to a well-designed incentive system to support banks’ feasible expertise on risk management. And each bank should create
strategic plans. The incentives approach would run thus: teams that help recover loan defaults and enlarge loan-making
(i) Pick up in the initial phase a few banks that have maximum capacity. These teams should also follow closely the progress of
amount of NPAs, say eight in number. each loan account. Bail-in option should not be used except in
(ii) Adopt for the chosen eight banks, plans for recovery and extreme bank crisis situations, but it appears that with large
growth for the next three years as outlined under our first capital infusion, the bail-in option may appear irrelevant for the
approach. present. However, it is best to have this option on the lines indi-
(iii) Let the chosen eight banks issue financial recovery and cated in this paper in view of the many economic uncertainties
viability (FRV) bonds of three-year maturity. These bonds and unknown behavioural responses of policymakers.

note moral hazard of supporting banking firms in deep Bernanke, Ben (2008): “Testimony: US Financial
1 The former Fed chairman, Ben Bernanke gave distress. However, Bernanke later seemed to Markets,” Committee on Banking, Housing,
a testimony on 30 September 2008 before the have held a slightly different view on the subject. and Urban Affairs, US Senate, 23 September,
US Senate Committee on Banking, Housing http://www.federalreserve.gov/newsevents/
and Urban Affairs with specific reference to the References testimony/bernanke20080923a1.htm.
failure of the Lehman. In his words, “the trou-
bles at Lehman had been well known for some Avgouleas, Emilios and Charles Goodhart (2015): Ghosh, Soumya Kanti (2017): “Do We Need an
time, and investors clearly recognised … that the “Critical Reflections on Bank Bail-ins,” Journal FRDI Bill?” Business Standard, 21 December.
failure of the firm was a significant possibility. of Financial Regulation, Vol 1, No 1, pp 3–29. Shah, Ajay (2017): “The Third Element of the Exit
Thus, we judged that investors and counterpar- Framework,” Business Standard, 11 December.
Bandyopadhyay, Tamal and Achintan Bhattacharya
ties had had time to take precautionary meas-
ures” (Bernanke 2008). This is a subtle way of (2018): “The Why and Hows of Public Sector Summers, Larry (2017): “Will the Center Hold,”
suggesting that the Fed would not take the Bank Recapitalization,” Mint, 8 January. Project Syndicate, 21 December.

Economic & Political Weekly EPW MARCH 31, 2018 vol lIiI no 13 143