The draft bill on resolution of financial firms, which includes an option to bail-in senior creditors, is likely to face political obstacles and will require strong consensus for implementation, Fitch Ratings said today.
After enacting a bankruptcy code for time-bound settlement of insolvency cases in non-financial firms, the finance ministry last month released a draft bill to set up a resolution corporation to address similar issues among financial firms.
India currently lacks a comprehensive policy framework to deal with the failure of financial institutions. Resolution powers for the financial sector are limited and scattered across several regulatory bodies, Fitch said.
"A new draft bill has brought India one step closer to creating a financial institutions resolution framework that includes an option to bail-in senior creditors. However, a strong political consensus will be required if the plan is to be implemented in its current form," it said.
The lack of a specified timeline suggests its passage is not an immediate priority, and policymakers are likely to be wary of any changes that might make it more difficult for banks to attract funding, it said.
The draft bill aims to create an independent Financial Resolution and Deposit Insurance Corporation (FRDIC) with responsibility for a wide range of financial institutions.
"However, the bill is likely to face obstacles in Parliament. The governing acts of various public-sector entities would need to be amended to give the FRDIC sufficient powers to perform this role. Fitch believes it may be difficult to generate political support for such an overhaul," it said.
Under current law, insolvency in public banks cannot be resolved without government permission. RBI has historically used mergers as a resolution mechanism in the banking sector, with losses imposed only on shareholders.
Any perceived weakening of state support could erode creditor and depositor confidence, creating funding risks for public banks - which account for nearly 75 per cent of banking assets and are key to the politically important objective of increasing financial inclusion, Fitch said.
Fitch said the option to bail-in senior creditors is
likely to be particularly contentious. It would see senior creditors effectively ranking below depositors, instead of pari passu, instead of on equal footing.
A bail-in aims at rescuing troubled financial institution by making its creditors and depositors take a loss on their holdings.
"This distinction would reduce the moral hazard that has developed around the assumption that government support will protect creditors from losses at different levels of the capital structure," it said.
However, the risk of senior debt bail-ins could have market access and pricing implications for banks' future bond issuance at a time when their financial positions are already fragile.
Appetite for bank Additional Tier-1 capital instruments could also be affected to the extent that investors view the government as becoming more willing to allow them to take losses. Banks already face a significant challenge in making up large capital shortfalls over the next couple of years, it said.
If the draft bill is passed in its current form, its wording indicates that the strong preference will still be for regulators to work toward returning financial institutions to health.
Bail-ins and liquidation will be a last resort, with the FRDIC only becoming involved at a late stage, after efforts to revive the institution had not worked as planned.
Fitch said this suggests there will be a strong likelihood that the FRDIC would only be willing to apply to bail-ins to small, private, non-systemic banks.
