Protecting banks against failures

It is some coincidence that a movie titled Everything, everywhere all at once stormed the Oscars the same weekend a storm hit the US banking and financial markets affecting everyone, everywhere and all at once. In a couple of days, the tremors reached Europe and then left banks around the world looking closely at their balance sheets and, in particular, the composition of their uninsured depositor base, their asset-liability mismatches and the interest rate risk on their sovereign books to see whether they could also come under fire.

Pundits began publishing lists of the next set of banks with similar business models or portfolios that could go under, contributing to the nervousness in the markets.

Deposits moved from smaller banks to the big ones on the assumption that these would not be allowed to fail given their systemic importance, and banking stocks reeled in a manner reminiscent of the Global Financial Crisis (GFC) of 2008.

The reaction from the authorities was quick and they signalled their willingness to stand behind all depositors while the Federal Deposit Insurance Corporation (FDIC) moved to resolve the failed banks.

In the Indian context, state ownership of the majority of bank assets offers implicit assurance of safety for their depositors. For the remaining, the authorities have demonstrated the willingness, at times compulsion, to bail out troubled banks and FIs through either forced mergers, or sometimes through regulatory forbearance and unconventional regulatory engineering. This happened in the case of the Punjab and Maharashtra Cooperative (PMC) Bank bailout.

Further, the stigma attached to bank failures under any political regime has propelled the authorities to convince willing banks to fund a collapsing bank or to invoke fine prints, obscured in covenants and agreements, to rescue such banks. Other pressures, mainly public voice, have also brought this compulsion upon the regulator to use this option.

During the last three years, India has witnessed three bank failures — PMC Bank, YES Bank and Laxmi Vilas Bank. The regulator, with some hand-holding by the government, has not failed the depositors of any of them. In fact, so much is the pressure of public voice that India has not even allowed software companies to fail.

Deposit insurance, a legitimate instrument to minimise the impact of bank failure, has been used sparingly in India. This has raised other issues. Deposit insurance in India has long been funded by the banks themselves. Banks’ contributions are, however, not ‘risk-priced’.

This means that every bank covered under the Deposit Insurance and Credit Guarantee Corporation of India Act pays premium to insure its deposits at the same rate irrespective of its quality of assets and financial health. Stronger banks have often resisted this.

Although depositors have so far ultimately been paid back through deposit insurance, the measures taken to suspend operations for a brief and uncertain period — the moratorium — scuppers the customers, especially small depositors, as their funds are stuck. Meanwhile, formal mechanisms for expeditious liquidation of banks like the proposed Banking Resolution Corporation have not fructified.

Apart from the depositor trauma and investor losses, bank failures can lead to a rise in fees and interest rates as banks would look to cross-subsidise their losses. Worse still, one bank failure could lead to a chain of failures due to domino effect and even a sharp pull-back in bank lending, slowing down the economy. No central bank would ever welcome such a banking crisis.

So, what next?

The Silicon Valley Bank (SVB) episode has opened up many-an-old discussion. Should supervision be with central banks or does that conflict with their ability to combat inflation? Should regulated entities, whether in the private or public sector, be represented on the board of supervisory agencies, or do they impact the ability to conduct independent supervision? Should international standards be applied to all banking institutions and, if so, is it possible to craft supervisory expectations of risk management that are proportionate to their risk profile?

Or, should deposit insurance be 100 per cent (that is in value terms and number of depositors) not just in practice but also in policy, with costs shared by all stakeholders (central bank, banks, depositors’ protection fund and government) through innovative instruments and funds? Will this increase moral hazard and create greater incentives for risk-taking, and if so, how should this be kept in check?

Banks were always considered special because they play a key role in financial intermediation. But they face the risk of depositor runs, which are contagious. Hence, they are subject to prudential regulation and have access to special safety nets. The original mandate of the regulators has been expanded over time from depositor protection to financial stability in the face of systemic risks, which are heightened by a highly interconnected financial system as was evidenced in the GFC.

Thankfully, the lessons of that crisis were learnt and an impressive list of enhancements of regulatory and resolution policies and supervisory and enforcement practices rolled out in record time. Yet, implementation of these reforms remains uneven across the G20 fifteen years later.

The RBI has been taking a series of measures to strengthen Indian banks and the financial system as a whole. Depositors should repose faith in its ability to safeguard their interests. India’s leadership of the G20 offers an opportunity to reinforce the importance of the post GFC regulatory agenda. Implicit guarantees, unfunded insurance and shotgun mergers may help stem the bleeding in a crisis, but in the long term it is the full implementation of international standards in regulation, supervision, governance, resolution and deposit insurance that will best help convince the markets of the stability of the banking system.

Rath is a former central banker, and Narain is a former Deputy Director of the IMF. Views are personal

COMMENT NOW