By Anirudh Rao Saxena and Anupriya Nair, Fourth-year students at NALSAR, Hyderabad

An air of uncertainty and impermanence surrounds the future of the Indian financial system as a result of COVID-19. On 11th July 2020, speaking at the State Bank of India (SBI) economic conclave, RBI Governor Shaktikanta Das voiced his concerns pertaining to a likely increase in cases of capital erosion and non-performing assets (“NPA”) in the banking sector, as a result of the pandemic. As a contingency response to these vulnerabilities, he proposed the setting up of a resolution corporation (“RC”) with requisite legislative support to aid in the insolvency management of financial firms.

Chronology of Events

The necessity to establish an RC for insolvency and liquidation proceedings of Financial Service Providers (“FSPs”) was originally observed in the controversial Financial Resolution and Deposit Insurance Bill, 2017 (“FRDI”). The late Finance Minister (“FM”), Arun Jaitley, in August 2017, launched the FRDI in the Lok Sabha. Subsequently, in August 2018, interim FM Piyush Goyal withdrew the FRDI owing to public anxieties surrounding a ‘bail-in’ clause which was put in place to combat issues of inadequate deposit insurance.

In February 2020, FM Nirmala Sitharaman announced that although the revival of the FRDI is in the works, the Ministry of Finance cannot commit to a timeline for it to be tabled in Parliament. Currently, media reports suggest speculation around a forthcoming revised Financial Sector Development and Regulation (Resolution) Bill, 2019 (“FSDR”) in accordance with a briefing note prepared by economic affairs secretary, Atanu Chakraborty.

A Primer on FRDI

The prime reason for the introduction of FRDI was due to the increasing interaction between the public and the financial sector. It was owing to this very reason that the government felt a need to protect the interests of the depositors. Furthering this intention, the government introduced the contentious FRDI Bill, 2017 in the Lok Sabha.

Presently, India lacks an all-inclusive and integrated legal framework for the resolution and liquidation of financial firms. The responsibilities and powers for resolution are dispersed amongst regulators, Courts and the Government under multiple laws. These powers are quite limited, therefore banks are typically restricted to two methods of resolution i.e. winding up of the bank or mergers. Further, the impact of failure in case of a traditional insolvency procedure is limited to the creditors of the insolvent firm, however the failures of financial providers have a much wider ramification on the economy of a country (Cypriot Financial crisis). Thus, just as the Insolvency and Bankruptcy Code, 2016 (“IBC”) has provided a comprehensive resolution mechanism for non-financial firms, the FRDI Bill aims to do the same  for financial institutions.

What Triggered the Withdrawal of FRDI?

The foremost trigger behind the withdrawal of the FRDI was the questionable ‘bail-in’ clause found in Section 52 of the Bill. This section allowed for, if the RC saw fit, the internal restructuring of liabilities (deposits). Moreover, further sub-sections of the clause provided for the cancellation and modification (into long-term bonds and equity) of deposits. It is notable that the extent of the powers of the RC in this regard would be applicable on deposits only beyond the insurance cover amount of INR 1 lakh. Inevitably, this clause led to apprehension among depositors owing to the possibility of being left with a mere 1 lakh in case of bank failure.

In response to public concerns surrounding the ‘bail-in’ clause, not only the Ministry of Finance, but the late FM Arun Jaitley himself, presented the clause as a transparent means of granting additional protection to deposits. Au contraire, The Associated Chambers of Commerce & Industry of India (“ASSOCHAM”) argued against the clause, bringing focus to the dangers of diminishing trust in the banking system and of the consequent routing of public investment into unsuccessful avenues leading to the eventual erosion of the banking system. The competing objectives of the Bill, and that of the depositors, led to debate resulting in the withdrawal of the Bill.

The Revival of FRDI in 2020: Understanding its functioning

FRDI aims to provide establishment of a RC and a regime which would enable a timely resolution of failing financial firms. The RC will consist of representatives from all financial sector regulators (the Reserve Bank of India, the Securities and Exchange Board of India, the Insurance Regulatory and Development Authority of India and the Pension Fund Regulatory and Development Authority), the ministry of finance as well as independent members. It aims to achieve timely intervention by classifying firms into 5 categories – low, moderate, material, imminent, or critical. Determining the health of a financial entity, ensures that a timely decision can be taken before it’s classified as a weak entity and there is no other option left but to liquidate the firm.

The liquidation waterfall mechanism sets up a priority in terms of dispersal of payments  on the occurrence of liquidation. According to the hierarchy, first priority is given to secured creditors, followed by unsecured creditors, and finally by operational creditors. Under the current regime regulated by Deposit Insurance and Credit Guarantee Corporation (“DICGC”), the deposits are insured up to INR 1 lakh  over which the deposit is treated on par with unsecured creditors. However, as per the provisions of the FRDI Bill, these uninsured deposits will be placed above unsecured creditors and Government dues. FM Nirmala Sitaraman, in her 2020 budget speech, announced that the limit for insured deposits would be increased to INR 5 lakhs. This move would ensure improved protection of the rights of the depositors since a larger sum of deposits are protected. For this transition to occur in a seamless way, the FRDI Bill would have to transfer the deposit insurance functions from the DICGC to the RC which would then result in an integrated approach to the depositor’s protection and resolution process.

Decoding the Status Quo

The status quo of FRDI may be ascertained from the assertions made by RBI Governor Shaktikanta Das as part of his recent speech at the aforementioned SBI economic conclave. On account of similarities between his proposal and the FRDI with respect to the suggestion to set up an RC, the re-emergence of a revised FRDI may be easily perceived.

First, Das drew attention towards the increased relevance of resolution as opposed to liquidation of banks. He cited resolution (wherein the bank remains a going concern) as being more effective in providing depositors with a higher value of return.

Second, the traditional merger approach often utilized to save failing banks by merging (The merger of Corporation Bank and Andhra Bank with Union Bank ) with larger banks, doesn’t provide the same return as the resolution process.

Third, Das stressed upon the necessity to have the RC acting beyond simple implementation of corrective measures. The primary focus of the RC, as he stated, is not to correct, but to monitor, foresee and assess emerging risks as and when they surface.

Interim Mechanism

On 15th November 2019, the Ministry of Corporate Affairs (“MCA”) notified the Insolvency and Bankruptcy (Insolvency and Liquidation Proceedings of Financial Service Providers and Application to Adjudicating Authority) Rules, 2019 (“Rules”) with the objective to provide a framework for insolvency and liquidation proceedings of FSPs other than banks.

The Rules shall be applicable to FSPs (to be notified by the Central Government) as per Section 227 of the IBC including discussions with appropriate regulators, for the purpose of conducting insolvency and liquidation proceedings within a specified time frame. It is imperative to comprehend the provisional nature of the framework provided under Section 227 as it has been set up as an interim mechanism until either a revised legislation is enacted, or the IBC is amended.

The Way Forward

It is important to analyze and address the position FSDR will take in its proposed reforms. The bail-in clause was problematic in the FRDI owing to the lack of coherent legal framework within which it operated. This ultimately resulted in disproportionately disadvantaging individuals while leaving the corporate and financial sectors unharmed. In order to preserve financial stability, it is essential that the new Bill is strategically designed to establish a balance between the rights of private stakeholders and public policy interests.

The FSDR should consider including the “no creditor worse off test” in order to safeguard stakeholder interests. This move will convince investors that the bail-in provision is merely a way in which the bank buys time to restore its strength and long-term viability. This framework has been tried and tested during the 2011 Denmark financial crisis, and was advocated by the International Monetary Fund. It is of utmost importance that the bail-in framework is carefully structured to ensure effective implementation in the FSDR.

Additionally, owing to the constant changes in the dynamics of the banking sector with various mega sector banks undergoing mergers, it would be ideal to wait until there is better clarity on the future of the banking sector before introducing a new Bill. In order to better incorporate the legislative framework of other acts with the functioning of a new Bill, multidisciplinary research should be conducted before its enactment.