End of a long rope

There's need for an insolvency framework for financial sector

The Reserve Bank of India (RBI) finally stepped in last week and decided to use the powers granted it under Section 45 of the Banking Regulation Act to deal with the YES Bank crisis. It has, for a month, superseded the board of the bank and imposed several other restrictions on its operations. Customers will not be able to withdraw more than Rs 50,000 and it cannot take on any new liabilities. There are two questions that should be asked in any such case and particularly in this case. The first is: Was there a delay in acknowledging the seriousness of the problem? And, second, what comes next?

 
It certainly appears that the erstwhile promoter-manager of YES Bank, Rana Kapoor, was granted a very long rope by the authorities and that action should have been taken to deal with the financial institution and its management long since. The charges against Mr Kapoor, who has been arrested, are serious, even though not proved as yet. The Enforcement Directorate has accused him and his family of setting up shell companies that were used for receiving kickbacks from corporate entities that took loans from YES Bank. The RBI has put into place an administrator, a former chief financial officer of State Bank of India (SBI), who has sought to reassure bank customers that their deposits are safe.

 
Yet reviving YES Bank at the time of a general slowdown in economic activity and optimism is a tough ask. The first step will be to put in a strong management that can work in the meantime to push forward the government’s plan for revival. The bank, India’s fourth-largest in the private sector, is to be taken over by a consortium led by SBI, in what is essentially a bailout. The new management will have to properly audit the books and return operations, especially withdrawals, to normal at the earliest. Investigations into wrongdoing by the previous ownership and management are of course ongoing, and should continue.

 

But the priority now must be to restore confidence and to ensure there is no contagion. The problem is that banks like YES Bank should ideally be allowed to unwind in an orderly manner. No market system works properly if a bailout organised by the government is the only cost to a company that has taken bad decisions. But the issue is that there is no resolution framework in place for a financial institution that has to go bankrupt. A previous attempt in this government’s earlier term lapsed following concern that depositors’ money would be used to “bail in” failing banks. Of course, there is always the risk of contagion in the financial sector and so it is understandable if the state has been forced to bail out YES Bank with some cost to the nationalised banks. Yet that cannot be the only option. There must be an institutional structure and legal framework that can support the exit of a large deposit-taking financial firm in such a way that depositors are protected, assets are not destroyed, and incentives for promoters are clearly maintained. The regulator and the government were slow to react to the problems of YES Bank. It should not be slow in responding to the deeper failures that the YES Bank bailout has revealed. Since the role of private financial institutions is likely to increase over time, financial sector regulators, including the RBI, need to be more proactive.