From UPSC perspective, the following things are important :
Prelims level : AT-1 bonds.
Mains level : Paper 3- Issues involved in banking system and resolution process in case of failures.
Resolving bank failure is tough but following a set of principles could achieve a fair and efficient outcome.
Key issues involved in the resolution
- Challenge in courts: Resolving Yes Bank’s failure is no easy task. Some bondholders are already challenging the restructuring plan of the Reserve Bank of India in court, and seem ready for a long-drawn battle.
- How much dilution is fair for existing shareholders to take?
- AT-1 Bonds issue: Should the value of the Additional Tier 1 (AT-1) bonds be written off entirely?
- As such issues become matters of policy discussion and address, we must not lose sight of some fundamental principles of resolving bank failures.
- Three of them should be on the top of the list: honour contracts, address market failure and protect systemic stability.
How honouring contracts matter for economy?
- For efficient outcomes: Honouring contracts is vital for achieving efficient outcomes between contracting parties such as lenders and borrowers, managers and shareholders, and insiders and outsiders.
- Shying away from entering a contract: If there is uncertainty over this fundamental principle, contracting parties will shy away from entering contracts in the first place.
- Lenders will be less willing to lend.
- Prospective minority shareholders will be less keen to buy shares in a company.
- Impact on allocative efficiency: This will ultimately compromise the economy’s allocative efficiency, or the market’s ability to deploy capital to its best use.
AT-1 bond issue
- Honouring contract in Yes banks resolution: There are several issues in the application of this principle in Yes Bank’s resolution.
- The most visible one concerns the decision of writing off its perpetual contingent, or AT-1, bonds.
- Write off: According to the original agreement, these additional tier-1 (AT-1) bonds are indeed supposed to be written off at a time like this.
- And this write-off need not happen before the common equity value goes down to zero.
- The entire idea behind these perpetual contingent bonds is to improve a bank’s capitalization if its common equity value falls below a certain threshold, but does not hit zero.
- Counter argument: These bondholders and some commentators are arguing that writing off those bonds will be a big blow to India’s bond market.
- Moral hazard problem: This is just the opposite of the truth. Not writing them off in accordance with the original contract will create a severe moral hazard problem.
- What incentive would any bondholder have to correctly price and monitor these banks in the future?
- Market discipline would die a quick death, and the bond market will suffer in the long run.
- What the resolution process should do? Therefore, the resolution process should honour the contract and write off the entire value of Yes Bank’s AT-1 bonds.
Dealing with critical market failures
- Second core principle: The second core principle in this resolution should be to tackle some critical market failures that led here.
- Several observers have pointed out the failure of board oversight, promoter negligence and reckless lending at the bank.
- Vital market failure in the purchase of AT-1 bonds by retail investors: Indeed, these issues must be addressed. But there seems to be another vital market failure hidden in this crisis: the purchase of AT-1 bonds by retail investors.
- Why AT-1 bonds are complex? AT-1 bonds are “information-sensitive” instruments, which means that the value of these instruments is extremely sensitive to information on the firm’s fundamentals.
- Complex financial security: They are very complex financial securities. Understanding the risk and reward associated with these securities and valuing them properly is not an easy task even for the best of market professionals.
- Retail investors are certainly not suited to buy this product. Still, several of them ended up holding Yes Bank AT-1 bonds in their asset portfolios.
- Demand deposits and market failure: Banking theory relies on the idea that demand deposits are information-insensitive instruments.
- Hence, a retail investor can place deposits in a bank without worrying about understanding the real risks borne by it. Government-backed deposit insurance makes deposits even more liquid and riskless.
- Hence, retail investors should hold regular deposits in a bank, and not complex securities like AT-1 bonds.
- Where is the market failure involved? If such bonds are sold to them without proper disclosure of the associated risks, then it amounts to a serious market failure.
- Way forward: This market failure must be corrected.
- Holding investment advisors to higher standards of fiduciary responsibility is one way of doing so.
- Prohibiting retail investors from investing in such securities is another critical step to prevent such a market failure.
Way forward to carry out the resolution process
- Restitution of value to retail investors: Meanwhile, the resolution process could consider partial or full restitution of value to retail investors in Yes Bank’s AT-1 bonds, if these products were indeed mis-sold to them.
- Large professional investors should be treated differently: But such a rescue must not extend to large professional investors who willingly bought these bonds for higher returns.
- One mechanism to do this could be to create a separate fund for retail investors with investments capped at a certain point.
- Or, their AT-1 investments up to a specific limit could be converted into a simple deposit contract. The legal hurdles may be insurmountable.
- However, in principle, those who mis-sold these products to retail investors should be required to compensate them.
- Conflict in two principles: Sometimes, these principles can come into direct conflict with each other.
- If the resolution allows retail investors in those AT-1 bonds to recover their investments, it would go against the “honour the contract” principle, but it would address the “market failure” issue.
- Ensuring systemic stability: How should we reconcile this conflict? That’s where the third principle comes in: ensuring systemic stability.
- After all, the regulator’s main objective is to restore the market’s faith in the country’s financial system.
- While this is not an easy task, protecting the capital and confidence of small investors can go a long way in restoring their faith in the banking system.
Resolving bank distress is never an easy job. But honouring contracts, addressing market failure and ensuring systemic stability can together go a long way in achieving a fair and efficient outcome.