Business Standard

<b>Bhargavi Zaveri:</b> New law should have firm foundations

By providing a definitive legal framework to deal with the resolution of financial firms, the draft Financial Resolution and Deposit Insurance Bill takes a leap of sorts in Indian financial regulation. But some chinks in the armour need to be fixed

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Bhargavi Zaveri
Late last month, the Ministry of Finance solicited comments on a draft Financial Resolution and Deposit Insurance Bill, which is the proposed legal framework for resolving financial firms. The draft Bill complements the recently enacted Bankruptcy Code, which does not automatically apply to the resolution of financial firms. The draft Bill also plugs another gaping hole in the Indian legal framework on the identification and resolution of systemically important financial institutions (SIFI). Simply put, SIFIs are firms, the breakdown of which can lead to a breakdown of the entire financial system. By providing a definitive legal framework for dealing with the resolution of financial and the too-big-to-fail firms, the draft Bill makes a leap of sorts in Indian financial regulation.

Briefly summarised, the draft Bill does three things. First, it sets up an independent resolution corporation (RC), which will be in charge of insuring bank deposits and resolving failed financial firms. Second, it lays down a prompt corrective action framework, which allows a financial regulator and the RC to intervene at an early stage of stress to ensure speedy recovery or resolution of a stressed financial firm. Depending on the probability of failure that the firm is at, it envisages interventions such as restricting dividend distribution and expansion of business, replacement of management, etc. Third, it prescribes some methods that the RC may use to resolve an insolvent financial firm, without disrupting the continuity of services to its consumers. While the resolution framework under the draft Bill is, thus, fairly comprehensive and largely on par with the recommendations of the Financial Stability Board, there is scope for improvement in three specific areas.

First, the draft Bill lacks a process for judicially reviewing the decision to designate a firm as a SIFI. The draft Bill rightly vests the power of identification of SIFIs with the central government, as opposed to the sectoral regulators. There are two reasons for this. One, systemic risk is a cross-sectoral concern and the information required to support the designation (or otherwise) does not lie with any one sectoral regulator. Two, in times of stress, a SIFI may need to be bailed out by the government. A bail-out being essentially a fiscal prerogative, systemic regulation is intrinsically connected with the exchequer. However, a SIFI designation has serious cost implications for the entity designated as such. For instance, it implies additional capital, stricter surveillance and a possibly restricted scope of activities. Hence, it is essential that a decision designating an entity as a SIFI be subject to judicial review, which is currently missing from the draft Bill.

The United States recently witnessed the judicial review and subsequent reversal by a US district court, of the decision designating Metlife Inc as a SIFI. Here, the fact that the decision to designate Metlife as a SIFI "focused exclusively on the presumed benefits of its designation and ignored the attendant costs', underpinned the reversal of the designation. In India, in the absence of a statutory appeal, one could approach the writ courts against such designation. However, the complexity of the considerations involved in a SIFI designation warrants a statutory appeal before a tribunal, which is equipped with technical skills to review such a decision.

Second, a plain reading of the Bill and the accompanying report suggests that the draft Bill is intended to apply to all financial service providers, unless they are specifically notified under the Bankruptcy Code. The draft Bill defines a financial service provider expansively to include all sorts of financial intermediaries, including those which render purely non-fund based services such as financial advisors, underwriters, merchant bankers, etc. This is a case of overreach for two reasons.

One, not all financial service providers warrant an early intervention framework of the kind envisaged under the draft Bill. For instance, take a small non-fund-based portfolio manager or a small broker, who merely manages the portfolio of her clients by executing buy and sell orders. An impending insolvency of such a simple financial activity should be left to the regular creditor-driven bankruptcy procedures applicable under the Bankruptcy Code, to other firms in the economy. This is true of a myriad of other financial firms, whose operations are fairly simple and whose breakdown poses no risk to the financial system at all. Being covered under the resolution framework under the draft Bill implies costs for the covered entity. We must, therefore, be circumspect before mandating all financial firms to bear this cost. Two, resolving a financial firm requires technical expertise, speed and resources. The RC must focus its capacity and resources on financial firms that require early intervention, quick resolution and seamless continuity of services to consumers. Hence, mandating the attention of the RC on all financial firms is both unwarranted and counterproductive.

The scope of the law must be limited to SIFIs and some categories of non-SIFIs such as banks, insurance companies and pension funds, whose resolution processes warrant state intervention because they make high-intensity long-term financial promises to consumers, and will not fit in the regular creditor-driven processes envisioned under the Bankruptcy Code.

Third, the draft Bill exempts mergers and buyouts of failing financial firms from the provisions of the Competition Act. While this exemption seems to be driven by process-efficiency considerations, the law should allow some scope for the Competition Commission of India (CCI) to impose ex-post conditions that could address competition-related concerns that may arise from a forced or voluntary combination of financial firms under the draft Bill. For instance, the CCI may mandate the combined financial firm to compulsorily divest certain business, as was done when the UK Treasury bailed out the Royal Bank of Scotland in 2008, to alleviate competition-related concerns.

All in all, the draft Bill is the way forward in dealing with stressed financial firms and partially sets the ball rolling on dealing with SIFIs in India. However, the RC, when set up, will wield extensive powers over the affairs of financial firms covered under the draft Bill. The only way to ensure that the powers are exercised judiciously, yet efficiently, is to build clear foundations in the primary law itself.

The author is a research associate at the Indira Gandhi Institute of Development Research
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper

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First Published: Oct 18 2016 | 9:47 PM IST

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