Duvvuri Subbarao: Bank resolution framework challenges in the Indian
context
Inaugural address by Dr Duvvuri Subbarao, Governor of the Reserve Bank of India, at the
International Association of Deposit Insurers (IADI)-Deposit Insurance and Credit Guarantee
Corporation (DICGC) International Conference "Role of deposit insurance in bank resolution
framework - lessons from the financial crisis", organized as part of DICGC's Golden Jubilee
celebrations, Jodhpur, 14 November 2011.
* * *
1. On behalf of the Reserve Bank of India, let me once again extend a hearty welcome
to all the delegates to this IADI-DICGC International Conference on the Role of Deposit
Insurance in Bank Resolution Framework - Lessons from the Financial Crisis. Welcome also
to this Sun City of Jodhpur - on the edge of the Thar Desert - a city of forts and palaces,
lakes and gardens, and folklore and legend that represents - in its mellifluous blend of
tradition and modernity - the best face of India.
DICGC
2. This conference is also part of the golden jubilee celebrations of DICGC which has
the distinction of being the second oldest continuing deposit insurance system in the world.
Over the past 50 years, the DICGC has been an important part of India's financial sector
development; it has grown and evolved, met many challenges and adapted to managing new
risks. On the way forward, the DICGC will have to reinvent itself to meet the rising demands
of a rapidly growing and structurally transforming economy. To do so, it has to learn from the
experience of deposit insurance systems around the world and also from the experience of
the global financial crisis. This conference, therefore, is an important learning opportunity for
DICGC to move up the value chain in its business.
Lessons from the financial crisis
3. The financial crisis has taken a devastating toll on global growth and welfare. Three
years on, the crisis is still with us; it has just shifted geography. In some respects, the 2008
and 2011 crises are similar. Both trace their origins to the mispricing of risk - of private debt
in 2008 and public debt in 2011. Both began from deceptively small sources - sub-prime
lending in the US in 2008 and government debt in Greece in 2011. The contagion impact in
both cases was enormous and destructive. There are striking dissimilarities between 2008
and 2011 as well. In 2008, the crisis revolved around private debt and complex financial
products making it difficult to determine where risk lay; in 2011, the crisis is centred around
public debt with much greater clarity on where exposure and risk lie. Most importantly, in
2008, governments were a part of the solution; in 2011, governments are the problem. In
2008, we were dealing with unknown unknowns; in 2011, we are dealing with known
unknowns.
4. What is striking, and what is important from the view point of this conference, is that
no matter where a financial crisis originates, no matter what the causes are and no matter
how it evolves, banks become the centre of the crisis. And when banks come under stress,
deposit insurance becomes a critical variable in containing the crisis and restoring
confidence. To be able to discharge this responsibility efficiently and effectively is then the
challenge for the deposit insurance system.
5. The global financial crisis has triggered a re-examination of how financial safety nets
function and of the relationships among supervisors, bank insolvency agencies and deposit
insurers. The crisis made us realize that depositors are more risk-sensitive than we had
thought. More than ever before, we know that the threat of even small losses can lead to
destabilizing runs. This reinforces the case for a truly integrated policy response to shocks,
where agencies responsible for supervision, regulation, insolvency and deposit insurance act
quickly and in a well-coordinated manner.
6. We also learnt from the crisis that three pillars are required to support a resilient
financial system. The first pillar is effective supervision. Important lessons have emerged
from the crisis on making supervision stronger and more effective. The second pillar is a
robust regulatory framework that integrates a system-wide approach and has built-in buffers
to smooth cyclical volatility. And the third pillar, the theme of this conference, is a resolution
framework that is quick and effective, and one that creates the proper backstop to efforts at
limiting excessive risk.
7. There are varying models around the world on how responsibilities for the above
three pillars are allocated across different agencies. The specific regulatory architecture of a
country has implications for the role and mandate of the deposit insurance system. In some
cases, deposit insurance systems are actively involved in the resolution process, in some
cases less actively so, and in some cases not at all. In India, bank resolution rests entirely
with the regulators and supervisors, and the DICGC plays only a pay-box role. I thought it
appropriate therefore to use the platform provided by this conference to highlight some of the
challenges we in India face in bank resolution, and in the process identify the tasks ahead for
DICGC.
Indian financial architecture
8. Before going on to discussing the challenges of bank resolution, let me set the
context by giving a big picture of the financial system in India.
9. Our financial system comprises commercial banks, cooperative banks, non-banking
financial companies, insurance companies, provident and mutual funds, and the newly
emerging pension funds, with overall assets close to 140 per cent of GDP. Commercial
banks, comprising of 60 per cent of the total financial assets, dominate the financial system.
Within commercial banks, public sector banks, with nearly 75 per cent of total assets, have a
commanding presence. Commercial banks in India are well-capitalized; system-level capital
to risk-weighted assets ratio (CRAR) under the Basel II norms stood at 13.9 per cent as at
the end of June 2011, well above the Indian regulatory minimum of 9 per cent.
10. There are certain structural and regulatory features that make India's financial
system resilient to stress. Commercial banks are required to hold a significant proportion,
currently 24 per cent, of their assets as government paper. The Reserve Bank also
mandates a reserve requirement whereby banks are required to hold reserves with the
central bank to the extent of the Cash Reserve Ratio (CRR). And importantly, the fact of
government ownership of a large segment of commercial banks inspires public confidence.
Needless to say, all the insurance implied by the above regulatory and structural factors
comes at a cost, and we struggle with balancing the costs and benefits.
11. The Reserve Bank of India has an over-riding role in the financial safety-net
architecture in India - it has responsibility for regulation and supervision of banks in addition
to its traditional central banking functions. The Reserve Bank has broad resolution powers
over commercial banks under the Banking Regulation Act. DICGC, being a wholly owned
subsidiary of the Reserve Bank, works in close coordination with the central bank to offer
protection to small depositors.
12. A recent and significant development on the financial stability front has been the
setting up of the Financial Stability and Development Council (FSDC) under the
chairmanship of the Finance Minister with a wide mandate of systemic oversight, regulatory
coordination, financial sector development and promotion of financial literacy and financial
inclusion. A sub-committee under the chairmanship of Governor of the Reserve Bank acts as
the operational arm of the FSDC. It provides a mechanism for coordination among
regulators, and between regulators and the government which, as we realized during this
crisis, is critically important, especially during stressed times.
13. Failures of commercial banks in India have been rare. The last time we had a major
commercial bank coming under distress was in 2004 and that was resolved by effectively
and quickly merging it with another strong public sector bank. Failures among urban
co-operative banks are, however, quite common. For banks that fail to meet the minimum
prescribed requirements, we institute a regular monitoring mechanism. The weak bank is
required to put in place a plan of action indicating targets for critical financial parameters
including capital infusion. If weakness in the bank persists with net worth turning negative
and there is no credible action plan for a turnaround, it is put under a moratorium. The
purpose of imposing a moratorium is to prevent a run on the bank, stop asset stripping and
give time to the regulators to identify a suitable strong bank for takeover. The process of
merger is put through as expeditiously as possible in a transparent and consultative manner.
Importantly, in the Reserve Bank, we have a committee of the Board, the Board for Financial
Supervision, which reviews our bank supervisory function and monitors the performance of
banks, especially weak banks.
14. The typical resolution methods that we have used in India are assisting the troubled
bank in restructuring, or merging it with a strong institution, or closure. The most common
method has been assisted or compulsory merger when the weak bank is merged with
another bank, usually a public sector bank. There were also cases of voluntary merger where
a healthy bank voluntarily took over a weak bank. Apart from making payouts to banks that
are put under liquidation, DICGC assists in mergers by meeting the shortfalls in depositors'
claims up to the coverage limit when the acquiring bank is unable to meet this liability. In
case of smaller urban cooperative banks, the general approach has been to liquidate the
bank with reimbursement made to depositors.
Bank resolution framework and deposit insurance
15. The financial crisis has underscored the importance of rapid resolution to arrest
contagion and restore stability. We need a resolution process where banks can be wound
down in an orderly fashion, removing the unsafe or unsound elements but preserving the
vital financial activities. International financial standard setting bodies like the Financial
Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS) have
emphasized the need for national authorities to have appropriate tools to deal with all types
of financial institutions in difficulty so as to help maintain financial stability, minimize systemic
risk, protect consumers, limit moral hazard and promote market efficiency. It is, of course, still
"work in progress".
16. Where do we in India stand on this? Even as we have been able to resolve problem
banks so far, it is not clear that our resolution framework has been put to severe test. There
are several questions. Is our resolution process quick and effective? What are the
fundamental resolution tools that we must have to confront not only small failures but the
possible failures of medium and large banks? What constraints would we face in preserving
value if our financial firms become globalized or systemically important? And importantly, for
DICGC, what is the optimal role for the deposit insurer in the resolution regime? Should we
consider an alternative distribution of insolvency responsibilities among the safety net
players?
17. Addressing these questions will require some fundamental changes in our legal and
regulatory framework. I cannot, and do not, intend to attempt an action plan in this regard.
What I will do, instead, is to present some specific issues and constraints in the bank
resolution framework of India.
I. Appropriate legal framework
18. The first challenge is developing a comprehensive legal framework for resolution
that covers all the different types of financial institutions. Currently, the relevant provisions
governing issues such as control of management, acquisition of the financial institution,
suspension of business and winding up, are all spread over different laws and regulations.
Moreover, different types of banks are covered by different statutes. For example, banks
which are constituted as companies are governed by the Banking Regulation Act, 1949 and
the Companies Act, 1956 [private sector banks and foreign bank offices]. The resolution
regimes for public sector banks, viz., State Bank of India, its subsidiaries, nationalised banks
and regional rural banks, which have been created by separate acts of Parliament, are
contained in their respective statutes. In the case of co-operative banks, the registrars of
co-operatives at the central or state-level are responsible for oversight of some aspects of
their functioning, including their winding-up and restructuring. Deposit insurance is covered
separately in the DICGC Act, but is not integrated with banking laws. All in all, the legal
framework governing bank resolution is spread all over, making the framework complex,
confusing and oftentimes non-transparent.
19. One big issue that needs to be addressed is whether the court-driven procedure as
followed in India for bank resolution can be made faster. The resolution process can be
further delayed if the shareholders of a bank challenge the authority of the regulator to
resolve the bank. In India, an enterprise proposing to enter into a combination via a merger
or an amalgamation is required to notify the Competition Commission, and the Commission
has been allowed up to 210 days to decide on it before the default clause kicks in. This
further complicates the resolution of banks through mergers and the uncertainty can be
potentially destabilizing. We have made a proposal to the Government to exempt bank
mergers from this provision.
20. We in India need to watch for "best practice" regarding the time frame for resolving a
bank. The process has to be quick enough so that creditors of banks, especially small
depositors, do not suffer undue losses and delays; maximum value is derived from the failed
or failing institution; and the shareholders bear the brunt of the loss. We also know that
markets penalize delay in decision making and uncertainty over the future of a failing
institution. This conference should deliberate on what is a reasonable timeframe for
resolution for different types of institutions that harmonizes various competing interests.
II. Extended role for deposit insurer
21. The second issue that we need to address is where the "resolution authority" should
lie - in particular, whether DICGC should have a more proactive role in the supervisory
framework to aid early identification of bank failures and their effective resolution. Over the
last fifty years, DICGC has done a good job in performing its "pay box" role. But in making
quick payments to depositors, it is handicapped by inadequate information sharing
arrangements regarding depositors. In India failures of commercial banks have been rare,
and the beneficiaries of the deposit insurance system have mainly been the urban
co-operative banks. While the regulatory and supervisory framework for urban co-operative
banks has over time been brought on par with that for commercial banks, the resolution
mechanism for these banks is not fully in the hands of the Reserve Bank; we share authority
with the central or state governments concerned. Because of this dual control, there are
delays in resolution of this segment of banks right from the appointment of liquidators,
gathering of information about depositors (which may not always be available in electronic
form), depositor payouts and recovery of assets.
22. Globally, deposit insurance systems, with broad mandates, are assuming a
significant role in the resolution of troubled banks. With access to information on risk
assessment of banks, they are able to take prompt corrective action. This arrangement gives
the insurer greater ability to address costs as compared to pure pay-box systems.
23. Deposit insurers adopt a "least cost" approach for resolving a failed institution. This
involves closer cooperation and coordination of appropriate actions taken by safety-net
participants, viz., the government, regulatory bodies, the central bank and the deposit
insurer. Experience shows that deposit insurers with sufficiently broad mandates, with
adequate powers, operational independence, and assured sources of contingency funding,
have been more effective in building and maintaining public confidence and dealing with
financial crises.
24. Some countries have undertaken a review of their deposit insurance systems and
resolution frameworks and instituted important changes. In India, we need to examine the
benefits of granting an extended mandate to the DICGC in resolution of failing banks from
the point of view of faster settlement to depositors, lower costs and speed of resolution with
associated benefits for the stability of the financial system. A solution to the problem lies in
putting in place a clearly defined solvency regime and a properly designed resolution
process. The Financial Sector Legislative Reforms Commission appointed by the
Government is comprehensively reviewing all the laws that apply to the financial sector with
the aim of making them supportive of an expanding and modernizing financial sector. It is
expected that the Commission will recommend a fundamental restructuring of some laws so
as to make the legal framework simple, transparent and efficient. From the Reserve Bank,
we will present our view before the Commission, and streamlining of laws relating to bank
resolution and reviewing the mandate of the DICGC will be part of our presentation.
III. Cross-subsidization
25. A third challenge that we have been facing arises from the heterogeneity of banks
being covered under deposit insurance. In particular, we have commercial banks and
cooperative banks whose laws and structures are different and their failure rates, as I said
earlier, are also different. But they are all covered by a uniform premium for insurance under
the DICGC. This inevitably leads to cross-subsidization of cooperative banks by commercial
banks. Illustratively, over five years, on an average, commercial banks contributed 92 per
cent of the premium received by DICGC while the entire amount of payout was to
co-operative banks, which account for only 14 per cent of the deposits insured by DICGC.
26. This cross-subsidization, or charging premium at a uniform rate from all categories
of banks, obviously raises a moral hazard. One option for reducing cross-subsidy is to
charge a risk-based premium, but we are not sanguine that this is necessarily optimal in
India. There needs to be a clearer assessment of the tradeoff between minimizing the moral
hazard and placing the additional burden of a higher premium on banks that are already
weak and yet serve the very important objective of financial inclusion. Another concern is that
imposition of risk based premiums could have a market impact, with stock prices of already
weak banks negatively affected by the burden of higher premiums. On the other hand,
crosssubsidization can, in fact, be justified by viewing higher premiums on larger banks as a
surcharge for their larger externalities on the rest of the system. I hope some of these
crosssubsidization and moral hazard issues will figure in the deliberations of this conference.
IV. Adequacy of deposit insurance fund
27. The fourth challenge I want to raise relates to estimating the adequacy of the
deposit insurance fund. Public confidence in deposit insurance will be determined largely by
whether the public believes that the deposit fund is large enough to meet its commitments.
DICGC maintains an ex-ante fund that is funded by the premium collected from insured
banks and income generated from investment of funds. For maintaining depositor
confidence, the fund is required to be robust enough to meet claims arising out of routine
failure of banks under normal situations. Going by the past record of failures, the fund
maintained by DICGC appears adequate. But it is not clear that the fund will be able to meet
claims arising from the putative failure of a couple of small or medium size commercial
banks. Admittedly, no deposit insurer can maintain enough liquid funds to face a widespread
financial crisis. In an extraordinary situation of systemic failure of banks, it is imperative that
the deposit insurer is armed with unlimited and quick access to funds from the central bank
and/or the government so that financial stability is not jeopardized. As we all know, it was
arrangements such as this that played a crucial role in containing panic among depositors
during the 2008 crisis.
V. Cross-border bank resolution
28. Another challenging area not only for us but also at the global level is cross-border
bank resolution. The main problem is differences in laws and regulatory frameworks across
countries which makes resolution difficult, inefficient and costly. There is clearly a strong
case for moving towards a more harmonized legal and regulatory framework.
29. In India, the presence of cross border banks is relatively small. But as the world
economy recovers and global trade and financial transactions grow, India will increasingly be
exposed to cross border risks. Now is the time to identify steps to make failure resolution
both fast and effective regardless of its provenance. We will need to strengthen relations with
foreign supervisory authorities, intensify information sharing, and consider ways to develop a
consensus on options for resolving a failing global institution.
30. A connected issue in this context, one that has been engaging our attention for the
past few years, is the appropriate framework for operations of foreign banks in India. In
particular, we are debating whether we should require compulsory local incorporation of
foreign banks. The organizational structure for cross-border banking groups differs across
the world and reflects the diversity of their business models and the varying stages of
financial development of different countries. Both the branch and subsidiary models have
merits as well as limitations. The predominant view globally is that under a branch mode, it
may be difficult to determine the assets that would be available in the event of the failure of
the foreign bank to satisfy local creditors' claims and the local liabilities that can be attributed
to the branch. The subsidiary framework provides greater regulatory control and comfort to
the host jurisdictions, apart from easing the resolution process. In crisis situations, the
distinction between the branch and the rest of the bank, and the legal location of assets and
liabilities can be really important. The Reserve Bank will be bringing out guidelines for the
presence of foreign banks in India based on the discussion paper that was released in
January this year.
VI. Resolution framework for SIFIs
31. The last challenge I want to raise is regarding regulation of systemically important
financial institutions (SIFIs). Oversight and regulation of SIFIs is currently high on the
international agenda, especially as they have a large presence in many countries and also
encompass a huge non-banking sector. The treatment of SIFIs requires a host of skills and
knowledge that all countries are struggling to understand. There is a debate on the
appropriateness of "systemic surcharges" that require SIFIs to hold additional capital. While
such higher capital will impose additional costs on the firms, the benefits by way of stronger
balance sheets that are able to withstand sharp financial shocks are expected to outweigh
the costs.
32. Equally importantly, we need to develop an effective resolution regime for non-bank
financial institutions. Setting new risk management and supervisory standards for large and
complex institutions is a huge task; their implementation will be even more demanding. So
far, the differences in the regulatory and legal treatment of banks and non-banks have been
understandable as their activities were concentrated in different markets. The emergence of
large complex financial institutions and groups that straddle both banking and non-banking
space makes the integration of such supervisory and resolution frameworks imperative. This
effort will require considerable time, resources, expertise and approach that incorporates a
system-wide analysis of risks.
33. Many Indian banks have grown and expanded to become "financial conglomerates"
offering different financial products in different markets. These can be construed as
"domestic SIFIs". This poses two challenges from a regulatory perspective - absence of
adequate legal framework and limited inter-regulatory co-operation framework.
34. First, enhancing the efficiency of resolution within the existing legal and regulatory
framework is one of the key responsibilities of the newly created FSDC. An important task
will be drawing up resolution plans that explicitly take into consideration information on
interlinkages among institutions. In addition, we also need to think in terms of a mechanism
similar to supervisory colleges for global SIFIs.
35. Second, the supervision of such conglomerates must start with an understanding of
banks' business models and risk profiles. The Reserve Bank has carved out a "financial
conglomerates monitoring division" to institute a system of close and continuous supervision
of large and systemically important banking groups. There are currently twelve institutions
falling under this category, accounting for 53 per cent of total assets of the banking sector.
We have also begun to apply a forward-looking approach by carrying out stress tests under
various scenarios as part of our half-yearly Financial Stability Reports. The FSDC
subcommittee is currently engaged in developing an institutional framework for inter-regulatory
coordination for monitoring large financial conglomerates.
Conclusion
36. The global financial crisis, as someone said, is too important to waste. We have, of
course, learnt a lot of lessons. We now know that financial markets do not self-correct and
that the costs of financial destabilization can be huge. We also know that the signals of
instability can be difficult to see in real time and we have therefore to be extra watchful. We
are also more sensitive to the need for putting in place quick, effective and transparent
resolution systems so that contagion can be arrested.
37. Another big lesson of the crisis has been that even as each of us has to learn from
the sum total of our collective experience, the solutions that we adopt have to be contextual
and tailored to country circumstances. This applies to the whole gamut of regulation and
supervision of financial systems including the operation of deposit insurance systems. I hope
this conference will take us closer to "thinking global and acting local". I wish your
deliberations all success.