Steering away from a one-size-fits-all formula

The draft Financial Resolution and Deposit Insurance Bill aims to devise the best possible solution, which takes into account the varied interests of creditors and consumers, while preserving the overall financial stability of the national economy

Anew draft law (Financial Resolution and Deposit Insurance Bill) for resolution of financial firms has recently been released for public consultation by the Ministry of Finance, government of India. The proposed new regime seeks to protect consumers and public funds to the extent possible, while maintaining overall stability and resilience of the financial system.

Unlike traditional insolvency where affected parties are limited to the creditors of the insolvent entity, the impact of failure of a financial firm, for instance, a large bank or an insurance company is much wider and can have a domino effect on the economy. Such a situation is by no means implausible or farfetched. The filing of bankruptcy by Lehman Brothers on September 15, 2008, was the first in a series of events, which precipitated the worst economic crisis in recent memory. As the stakes in cases of failures of financial firms are very high, the authorities responsible for resolution need to be equipped with necessary and appropriate powers to deal with such crises. In this background, the proposed new law provides for an array of resolution tools, which can be used by the “resolution corporation”, composed of representatives of the various regulators, the Ministry of Finance, as well as independent subject matter experts, in order to revive a failing financial firm. This piece discusses two of these proposed tools, namely “bail-in” and “transfer of assets to another entity”. Bail-in: As the name suggests, bail-in is the corollary of the traditional tool of bailout. Bailout implies infusing funds from a public source into a failed financial firm that traditionally benefits the shareholders or uninsured creditors of the firm. As the government is often the primary source of such a liquidity injection, more often than not, taxpayers end up becoming financially liable for bailouts. As a consequence, the public authority or the government assumes most of the risk of failure that would otherwise be borne by the firm itself, and this reduces the incentive among the management of a firm to make sound and prudent business decisions, leading to the problem of moral hazard, widely touted as one of the central issues of the financial crisis of 2008. Experience shows that the comfort of the “too big to fail” status had led to a series of decisions which were misjudgment at best, and speculation at worst.

Bail-in on the other hand moves away from the practice of using public funds and involves a number of restructuring mechanisms, including the cancellation or modification of liabilities owed by a firm (including converting instruments from one class to another and creating new securities), cancellation of contracts; and for central counter parties, haircuts on the margins and collaterals, and issuance of equity to the creditors. The tool of bail-in makes it incumbent upon creditors of the firms to assume at least part of the risk. Additionally, as bail-in impinges upon the substantial rights of creditors, it is imperative that this power is adequately circumscribed. The draft Bill envisages a host of safeguards, which must necessarily be complied with during the operation of this tool. Only certain specific types of debts can be written down, and liabilities like deposit insurance, wages and salaries, secured liabilities etc have been excluded from its purview. Further, the writing down of debts has to be done in accordance with the creditor hierarchy, and with due regard to “key attributes” identified by the Financial Stability Board (FSB), including the principle of “no creditor worse off than in liquidation”, continuity of essential services, and protection of client funds. Transfer of assets to another entity: This tool of resolution can assume a number of forms. For instance, it can be done in the form of a simple sale or purchase and assumption. Purchase and assumption is one of the most common modes of revival of a failing financial firm. The resolution corporation is responsible for overseeing such a transaction, which is carried out on the terms agreed between the resolution corporation and the third party. The features of this tool, as identified by the FSB, have been incorporated into the Bill, and include the power to transfer selected assets and liabilities of a nonviable firm to a third party, or to a bridge institution formed for this purpose. The distinctive feature of this transfer is that it does not require the consent of interested creditors or other parties. Segregating viable assets of the firm would also enable the resolution corporation and investors to take informed decisions about its health, and the exact amount of risk that is entailed. This may also serve the additional purpose of the non-viable assets to be liquidated while allowing continuity as a going concern.

The draft Bill also provides for a number of other resolution tools such as creation of a bridge institution, merger or amalgamation, acquisition, liquidation, or any combination of these. The objective is for the resolution corporation to be in a position to take over the reins of the firm and the powers of the individual regulators, to direct an orderly resolution, by the time the firm reaches a stage of unviability and enters the process of resolution. These tools are by no means exhaustive, and must be applied keeping in mind various factors, such as a firm’s type, peculiar characteristics, risk profile, the portfolio of creditors and investors, among others. Ultimately, the aim of this law is to steer away from a “one-size-fits-all” formula and devise the best possible solution, which takes into account the varied interests of creditors and consumers, while preserving the overall financial stability of the national economy.