Why discretionary bank rescues are not a substitute for systemic order

The 2020 intervention stopped contagion, but its ad hoc approach and breach of loss hierarchy underline the need for a predictable, rule-based system for failing financial firms

The successful resolution of the Yes Bank crisis in 2020 has been hailed as a stellar example of astute crisis management by the Reserve Bank of India (RBI), with a rapid mobilisation of public and private capital led by the central bank. Indeed, the swift containment of contagion was an operational success, preventing what could have been a systemic shock. 

However, to celebrate this episode as a model for future financial stability is to embrace a dangerous institutional mirage. The Yes Bank resolution was a victory of ad hoc expediency over systemic design. It violated all the well-known principles of good governance, rule of law, and financial regulation. It exposed the gaping, critical hole in India’s regulatory architecture: The continued absence of a non-discretionary, predictable framework for resolving failing financial institutions. 

At the outset, it is sobering to note here that India is the only G20 country that is not in compliance with the “Key Attributes of Effective Resolution Regimes for Financial Institutions” issued by the Basel-based Financial Stability Board. 

Let us understand the full picture. One piece of Indian institutional capability on firm failure is gradually coming together: The Insolvency and Bankruptcy Code (IBC). It is inching towards its goals of:

 

(a) invocation when the borrower has a tiny default, with no forbearance;

(b) clarity on loss allocation with a clear waterfall;

(c) a commercially motivated committee of creditors (CoC) that decides between resolution vs. liquidation and;

(d) speed. 

It is important to note that there is no significant role for the state in the IBC process. This is the hallmark of a successful market economy. The only role of the National Company Law Tribunal (NCLT) is to verify that there is an undisputed default, and that the CoC is formed and it votes correctly. There is predictability about what will happen, and how losses will be allocated, as this is written into the law. 

The most damaging legacy of the Yes Bank resolution lies in its violation of the universally accepted financial pecking order between equity and debt. At the foundation of the limited-liability company is the concept that equity holders are the first line of loss absorption; they hold the highest risk and are thus compensated with the highest potential reward. When a bank fails, the equity owners must lose all their money before any debt holder loses anything. 

In the Yes Bank case, the RBI-appointed administrator, in a move that continues to be litigated, decided to write down the entire ₹8,415 crore of AT1 bonds to zero. Crucially, this writedown took place without simultaneously wiping out common equity. Equity holders, while facing dilution through the subsequent recapitalisation, were nevertheless protected, retaining a non-zero value. 

This sequence of events inverted the risk hierarchy. It resulted in debt holders, who, by definition, stand higher in the pecking order than equity holders, being entirely wiped out while shareholders retained a claim. The message sent to the market was profoundly unsettling: In India, under an ad hoc resolution, the fundamental principles of finance are mutable, and the regulator reserves the right to arbitrarily alter the liability structure. 

Clarity and predictability are the oxygen of financial markets. This resolution was, institutionally, anything but clear. Beyond the inversion of the loss hierarchy, the Yes Bank saga highlighted a deeply entrenched institutional conflict: The RBI serves as both the banking sector’s supervisor and resolution authority. 

A core principle of modern regulatory governance suggests that the body responsible for preventing a failure (the supervisor) should not be the sole authority responsible for managing that failure (the resolution authority). If these lines are not maintained, there will always be a bias in favour of hiding and delaying the fragility of regulated firms, so as to cover up for failures of micro-prudential regulation. 

The Yes Bank failure was, at least in part, a failure of supervision in addressing the bank’s asset quality and governance issues before the situation became terminal. When the same entity is then tasked with designing rescue, the process is unlikely to be fully objective, non-discretionary, or transparently accountable for the supervisory lapse. Accountability demands that failure be managed through a mechanism separate from the agency that failed to prevent it. 

This strategic understanding of financial economic policy has been in place since the work of the Financial Sector Legislative Reforms Commission (FSLRC) was completed (2011-15). 

The future landscape must be organised as follows: 

First, we require a separate financial resolution corporation, which will work on pre-emptive closures of financial firms such as banks and insurance companies, where there is an important presence of unsophisticated households. This will work independently of the micro-prudential regulators. This building block is the substance of the Financial Resolution and Deposit Insurance (FRDI) Bill, 2017. This new organisation would also do deposit protection, up to ₹5 lakh per depositor, so as to immunise unsophisticated households from financial firm failure. 

The second component is the IBC. All other failures of financial firms are a simple matter of IBC resolution. As and when a default takes place, any operational or financial creditor should be able to trigger the IBC process, the NCLT would verify if there is an undisputed default, a commercially motivated CoC would then decide what to do. We do not require a public-sector organisation when private self-interest would suffice. 

The successful ad hoc intervention in 2020 should not breed complacency. It was a tactical win but a strategic loss for the development of a sound Indian financial system. The mark of a mature economy is not the absence of bank failures — which are inevitable in a healthy and competitive economy — but the existence of a clean, predictable, and rule-based mechanism for handling them when they occur. We must clarify the IBC so as to take all financial firms other than banks and insurance companies into the Code, and go through with the FRDI Bill for these two categories. These two steps should get the RBI and the Insurance Regulatory and Development Authority of India fully out of the end-game of failing financial firms.

The author is an honorary senior fellow at the Isaac Centre for Public Policy, and a former civil servant