A key test of the soundness of a country's financial system is the ability of its financial authority to resolve a failing financial firm in an orderly manner, with minimal disruption to its consumers, the system, or, in extreme circumstances, the global economy. A report published by the Financial Stability Board (FSB) reveals that India's resolution regime has a long way to go, and is ill-equipped to deal with failing financial firms.
The failure of domestic, small-sized financial firms imposes huge costs on households that are consumers of that firm, and by extension, on the economy as a whole. The failure of large, highly networked financial firms - also referred to as systemically important financial institutions, or SIFIs - can have disruptive effects on the global economy, depending on the size and interconnectedness of the firms, among other factors.
The aftermath of the global financial crisis of 2008 exposed many gaps in financial regulatory frameworks, including, notably, the absence of a mechanism to promote the orderly resolution of failing firms. Many acknowledge that the crisis was exacerbated because such mechanisms did not exist. As a result, financial firms collapsed like a row of dominos, forcing regulators and governments to pump in tax-payer money to bail these firms out, in an effort to reduce adverse effects.
The FSB - an international body that coordinates between national financial authorities, and of which the Reserve Bank of India (RBI) is a member - recently published its first peer review report on resolution regimes in its member jurisdictions. This peer review assesses the capabilities of countries based on certain "Key Attributes of an Effective Resolution Regime", which the Basel-based organisation had identified in an October 2011 publication.
A core requisite of an effective resolution regime, according to the FSB, is to have a dedicated resolution authority with a wide scope of powers, including being able to transfer assets and liabilities of failing firms to buyers, manage such firms, and be able to carry out winding up operations. Countries must also have a formal legal framework to systematically and frequently assess the resolvability of financial firms and SIFIs, and be able to direct changes in firm behaviour to improve resolvability. The FSB also recommends that, if a firm shows signs of trouble, the system should encourage the sharing of information about that firm to ensure an orderly resolution. It also recommends the establishment of a resolution fund that covers not only deposit insurance guarantees and compensation, but also finances the costs involved in the process of resolving a firm.
According to the April 2013 peer review, India lacks all of these key attributes, making its resolution regime among the weakest in the world. The review points out that India's capacity to resolve failing firms in the financial sector is very limited and narrow in scope. At best, the Deposit Insurance and Credit Guarantee Organisation (DICGC) pays out up to Rs 1 lakh to depositors of failed banks. However, no designated resolution authority exists for insurance and securities firms or financial market infrastructure firms (FMIs). The RBI also has limited powers to resolve private and foreign banks.
The peer review notes that nothing in law enables the RBI, or any other financial sector regulator, to conduct resolvability assessments of firms. Restrictions on sharing sensitive information about firms also significantly impede regulators' abilities to assess the health of a firm. And, while a deposit insurance fund (that collects fixed-rate, instead of risk-based, premia) exists, there is no dedicated fund to finance the resolution of banks and non-bank financial firms.
The FSB's peer review arrives contemporaneously with the report of the Financial Sector Legislative Reforms Commission (FSLRC), published in March 2013. The FSLRC report acknowledges all of these limitations in India's resolution capabilities, and makes legal recommendations in the form of the draft Indian Financial Code (IFC) to address these challenges.
For instance, the draft IFC creates a unified Resolution Corporation, separate from the RBI and any other financial regulator, that will carry out the orderly resolution of failing firms across the financial sector, under certain conditions. The draft IFC empowers the corporation to resolve and restructure not only banks, whether state-owned or private, but also insurance and securities firms and FMIs. The corporation will also have the power to transfer the assets and liabilities of a failing firm to another firm, or a specially-created bridge institution. It can take over the management or operation of firms, and take all necessary actions to wind up a firm. Recognising the need for proactive assessment and timely information-sharing among financial sector regulators and the Resolution Corporation, the draft IFC creates a formal framework of intervention by financial sector regulators and the Resolution Corporation, depending on the stage of financial health of the firm.
The draft IFC also creates a resolution fund that will, among other things, insure deposits, provide for compensation, as well as finance the costs of resolving firms. This fund, if managed and replenished appropriately, should reduce state intervention or the need to resort to taxpayer funds to deal with failing firms.