– Gaurav Chaliya, Jayesh Kumar Singh*
The fiasco of financial service providers [“FSPs”], in particular, Infrastructure Leasing and Financial Services and Dewan Housing Finance Ltd., acted as a trigger for the government to bring these companies under the insolvency regime. The recent crisis faced by Yes Bank as a result of corporate governance issues and fraudulent practises forced the Reserve Bank of India to restructure Yes bank. The lack of a robust and definitive governance framework such as the Insolvency and Bankruptcy Code, 2016 [“Code”] created a lot of turmoil in the Indian banking sector and increased the speculations about the closure of the bank. While Yes Bank has a scheme in place, the depositors of the failed PMC Bank still fear a loss of their deposits. These firms are substantially interdependent, and failure of any of them could trigger a market-wide financial instability. Through this article, the authors aim to highlight that there is a need of a separate insolvency regime for banks in India similar to other developed countries such as the United States, or possibly a more specialised regime such as the United Kingdom if amendments are to be made in the current Indian framework on bank insolvency.
Existing law applicable on the failure of banks
Section 3(7) of the Code defines ‘corporate persons’ and specifically excludes financial service providers. This definition becomes decisive as it forms the basis of defining ‘corporate debtors’ under the Code. Stating precisely, a corporate debtor is a corporate person who owes a debt to any person. Thus, it is clear that while banks can be a part of the Committee of Creditors formed against a corporate debtor, non-servicing of the debts by the banks would not bring them under the scanner of the corporate insolvency resolution process due to the aforementioned exclusion. Previous attempts and arguments to bring the FSPs under the ambit of the Code have already been denied in the cases of Randhiraj Thakur v. M/s Jindal Saxena Financial Services and Housing Development Finance Corporation v. RHC Holding Private Ltd. The primary reason behind this denial was that under Section 7 and Section 9 of the Code, only ‘corporate persons’ are entitled to file an application, excluding financial service providers.
Under the new set of rules notified under the Code in November 2019, the Ministry of Corporate Affairs felt the need to include the systemically important non-banking financial companies with asset-size of more than 500 crore rupees within the ambit of the Code. Prior to the notification of this rule, the resolution of all the FSPs was being managed by the sectoral regulators. Thus, since India lacks a special law to deal with the insolvency of banks, the Reserve Bank of India is empowered to rescue the banks under Section 45 of the Banking Regulation Act. It provides the central bank with the power to prepare a scheme of reconstruction of the failing bank, subject to the approval of the central government. Under Section 45(5)(f), the scheme may even reduce the rights or interests which the members or depositors or creditors have against the banking company. Thus, in the case of Yes Bank, RBI was completely within its powers to write off the liabilities owed by Yes Bank to Additional Tier 1 bondholders. While such drastic measures seem to be unjust considering the huge stake of bondholders and lack of a prior consent on their part to forego their claims in exigencies, the vires of Section 45 has already been tested and declared as constitutional by the Supreme Court in Shiv Kumar Tulsian v. Union of India. Instead of dealing with bank insolvency in such an equivocal manner by the RBI, it may seem that if the banks also were to be governed under the Code, they would be better off. The next section would highlight why the Code is not the ideal way to proceed ahead.
Challenges in the resolution of banks under the code
In order to point out the challenges that would be faced by the banks under the current insolvency regime, the threshold for default has been a major challenge. However, this has been sought to be cured by increasing the threshold from rupees 1 lakh to rupees 1 crore. It may seem unjust to expect an individual depositor to hold a minimum deposit of 1 crore as a pre-condition to initiating insolvency. However, the aforementioned amendment will not hinder the interests of depositors since, under Section 7 of the Code, they would have the option of filing claims on an aggregated basis should bank insolvency be governed by the Code.
Another glaring challenge can also be attributed to the creditor-driven nature of the insolvency process in India. Such a nature would not be feasible for the banking sector, owing to the interdependency in availing credit facilities. Considering the interdependency among banks with respect to borrowing and lending funds, the creditors may not work in the best interests of the defaulting bank and seek to wipe off competition from the market should an insolvency be triggered. Therefore, a more viable alternative would be to have an independent body to assess the bank at regular intervals, anticipate the likelihood of insolvency and take control of the bank. This is so as admittedly RBI is the chief regulator of the banks, however, there is an impending requirement of a specialised resolution entity which in turn would have multiple resolution tools, which are currently limited in case of RBI. Prominently two of the tools used by the RBI are, merger of a bank with another bank or liquidation, thereby, lacking in the other tools such as transfer, creation of bridge bank, and bail-in. In the past, the need for a specialised body to govern bank insolvency was recommended by the RBI itself. Additionally, a conciliatory mechanism can also be reached where the creditors would grant debt relief and extension in exchange for debt settlement guaranteed by an independent body. In general, this method aims at avoiding liquidation as it allows negotiation between creditors and debtors under appropriate authority. This negotiation aims at releasing some debt by the creditor and grants extension to the debtor for paying the remaining debt. The independent body works as a mediator which has a limited authority to intercede between parties.
Besides, the issue of the imposition of a moratorium on a bank’s operations is also problematic. Drawing from the reconstruction scheme of Yes Bank, the same can also be cured by carving out an exception to the moratorium requirement wherein the depositors would be allowed to withdraw their deposits up to a certain limit. In addition to it, since banks have vast numbers of creditors, the formation of a CoC for them is altogether a gruelling task. These are just some of the challenges that would arise if the resolution of banks is conducted under the Code. Thus, drawing lessons from international regimes, the next sections would depict why the banking sector needs a separate regime to govern its failures.
Resolution of banks: Lessons from abroad
In the case of free-market economies, the debacle of any entity is a natural phenomenon even in cases of bank failures. These situations need a proper mechanism as they affect the entire economy of the country and provide vital services. On one hand, while countries such as the United States have adopted a special law including both rehabilitation of the entity to avoid failure and liquidation mechanism, on the other, countries such as the United Kingdom have made significant amendments in their insolvency laws to effectively incorporate bank failures. The problems mentioned in the previous section do not arise in these regimes because of the predominant role played by the regulatory authority which takes over the bank upon a likelihood of failure.
- United States
In the US, there exist separate legal processes for the resolution of banks and corporates when faced with insolvency. While the former is an administrative process governed by the Federal Deposit Insurance Act [“FDI Act”] and favours the depositors over the debtors, the latter is a judicial process governed by the General Federal Corporate Bankruptcy Code [“General Code”] which favours the debtors over the creditors. Concerns of financial stability, consumer protection, and the unorganised and diverse creditor base form the basis of a separate system for banks. The FDI Act aims to maximise the net present value return from the sale of the assets, subject to the condition of a ‘systemic risk exemption’. Under the exception, the sale would be avoided if it results in serious adverse ramifications on financial stability and economic conditions. Such economic impact is minimised by continuing the distressed bank in business for rehabilitation with the help of a bridge bank.
The aim of a Chapter 11 bankruptcy under the General Code is to re-establish the firm as a ‘going concern’. An analysis of the different provisions in the FDI Act and the General Code reveals that while bank insolvency is anticipatory and initiated by the FDIC upon fulfilment of certain conditions, corporate insolvency may be initiated by the creditors or the management. Similarly, unlike corporate insolvency where a moratorium is imposed automatically, the FDIC can only request the court to defer all claims on the insolvent bank for a period of minimum 60 days. In the case of banks, the management shifts to the FDIC which is empowered to unilaterally take all decisions concerning the bank. Further, there is a certainty in claims, and the payment is done strictly according to the depositor preference criterion mentioned in the FDI Act. Additionally, unlike the CIRP which at times gets prolonged and results in the reduction of asset-value, the resolution of banks is mandated to be done as soon as possible, considering the impact its assets on the economy.
- United Kingdom
Considering the stance of the UK, prior to the 2008 financial crisis, general bankruptcy code governed the situation of failure of banks like any other entity. However, after the said crisis, the UK amended its legislation and established a special regime for bank insolvency viz. Banking Act, 2009. This Act provides for the Bank of England, HM Treasury, the Prudential Regulation Authority, and other such appropriate regulators with tools to safeguard the banks that got into the debacle. The special resolution regime contains five pre-insolvency stabilisation alternatives including a transfer to a private sector purchaser, transfer to a ‘bridge bank’, transfer to an asset management vehicle, bail-in, and transfer to temporary public sector ownership.
Evidently, these tools are used by an appropriate authority to protect and enhance the stability of financial service providers. Along with the tools, as specified, two insolvency options have been introduced, i.e., Bank insolvency and Bank administration. The former majorly corresponds to the liquidation procedure and the latter provides for partial transfer of business, which may be regulated by the court. According to the circumstances, favourable tools are being used by the appropriate authority to enhance the stability of the financial institution and to maintain public confidence in them. The paramount objective of Bank Insolvency is to ensure, in case of a bank fail, that depositors are paid promptly. In bank administration, a licensed insolvency practitioner is required to keep the residual bank as a going concern.
Broadly, it can be seen that most of the provisions governing bank insolvency in different countries having separate insolvency regimes or specialised legislation, other than general provisions, are similar and have worked successfully (See Wessels (UK) & Dudley (US)) for them. India also needs to follow a similar approach with tailor-made changes suited to the Indian scenario.
Need for a separate legislation governing bank insolvency
In India, the Financial Resolution and Deposit Insurance Bill, 2017 [“FRDI Bill”] sought to establish a dedicated ‘Resolution Corporation’ to cater to the resolution of financial firms which include banks, insurance companies, pension funds, depositories, and stock exchanges. However, the bill was withdrawn in 2018 by the government due to the criticism faced from the stakeholders and depositors, primarily on account of the bail-in provision. A bail-in provision provides that the creditors would bear a part of the cost of a bank’s failure by the reduction in their claims to some extent. This may be done either by cancelling the liabilities that the firm owes to the creditors, or by converting the liabilities into other securities, or in any other prescribed method. This provision failed to satisfy the creditors even though Section 55 of the bill provided that the creditors shall certainly redeem more value of their claims than what they would be entitled in case of a waterfall provision upon liquidation of the bank. Since the resolution process of NBFCs has already been notified, the re-introduction of FRDI Bill is intended to pave the way forward for the banks. The authors make the following suggestions for a makeover of the FRDI Bill.
The FRDI Bill, 2017, does not differ much from the practices followed in other jurisdictions, especially with respect to the initiation, procedure and resolution methods, and bail-in. Accordingly, the said bill provides for a resolution corporation, an independent body to monitor the banks and take appropriate action when the bank is labelled as critical among the risk categories which are a) low; b) moderate; c) material; d) imminent; and e) critical. This bill also lays down the provisions with respect to the bail-in method apart from other resolution tools. As per the authors, bail-in is the best suited method to preclude bank failure, as compared to its alternatives. That being so, the authors believe that bail-in provision is ad rem as it is better than its alternatives, namely, liquidation and personal insolvency law. Relating to the liquidation, there are always risks associated such as truancy of competitive markets and antitrust problems, however, bail-in suffers from neither and in addition, preserves the asset values. Concerning personal insolvency, it would be gruelling as it would require contractual formula for debt conversion and also in case of a bank failure, there is no time to wait for the dispute adjudication. As a result, almost all countries ranked in the top 10 of World Bank’s Ease of Doing Business Index released last year, in particular, Singapore, Norway, UK, and US, have incorporated bail-in clause into their respective laws.
However, in India, this provision being on the spotlight was largely criticised by the depositors and experts. To address their concerns and to improve the standard of corporate governance, there is a need to further protect the depositors’ interests. In this situation, the suggestions made by the authors are: first, the threshold for the insured amount of the depositors should be set in accordance with the savings of middle-class households. Currently, the deposits at the bank are insured by the Deposit Insurance and Credit Guarantee Corporation to the tune of 5 lakh rupees, which was revised in the Union Budget, 2020. Any impediment in raising this threshold can be overcome by following the premium based insurance model wherein banks would charge a premium for amounts insured beyond 5 lakhs. Although this mechanism may reduce the effective earnings of the depositors, the bail-in provision would become more acceptable to them. Second, the resolution corporation should undertake a preliminary appraisal of the possible effect of bail-in on the balance sheet of the other primary creditors. Through this exercise, those creditors which face the risk of insolvency if their assets are written off would be protected. This would alleviate the concerns of creditors with respect to bail-in to a great extent. Third, bail-in should only be used as a last resort, and only when the likelihood of restoration of the bank is high. The FRDI Bill should provide a hierarchical structure that shall be followed for resolution of banks. Once it is established by a report prepared by the resolution corporation that a particular resolution tool would not alleviate the problems of the bank effectively, only then should it proceed with the other tool in the hierarchy. Having such a clause in place would provide the much-needed assurance to the creditors and make the bail-in provision more acceptable to them. With these changes in place, we hope that the FRDI Bill will be acceptable to both small depositors and creditors.