Banking Sector Reforms

[op-ed snap] When a shadow bank is too indebted to fail

Note4Students

From UPSC perspective, the following things are important :

Prelims level : FRDI Bill

Mains level : DHFL crisis; Resolution

Context

India is struggling to plug a hole in its shadow banking industry that gorged on lending to the real estate sector.

Failure of Financial Corporations

    • Insolvency – RBI is expected to refer to Dewan Housing Finance Corp. Ltd (DHFL) for insolvency proceedings that are hastily tailored for financial companies. 
    • IBC inadequate – India’s bankruptcy mechanism is missing vital components. 
    • FRDI not passed – The government withdrew the Financial Resolution and Deposit Insurance Bill. 
    • Depositors’ money – It happened after an outcry over a clause that would have let depositors’ money gets converted into equity in the event of a bank or credit company turning insolvent. 
    • Deposit insurance – Adequate deposit insurance is the solution. Centre has got back to it after the collapse of Punjab and Maharashtra Co-operative Bank has caused so much distress.

DHFL resolution

    • We have a system that can preserve value for creditors who have lent the company ₹84,000 crores.
    • No legislation – There may not be a legislative apparatus in place. But India knows what needs to be done with collapsing financial institutions. 
    • G20 – The G20 financial stability recommendations were based on the premise that the market must address stress in the system. 
    • No overarching mechanism – We do not yet have an overarching body like the US Federal Deposit Insurance Corp., which can identify and resolve financial stress expeditiously.
    • This job is divided among India’s central bank and other financial sector regulators. 
    • NCLAT – Such cases can now be referred to the National Company Law Tribunal for resolution. 
    • Courts – The courts could also back the claims of underinsured depositors. Supreme court upheld the standard hierarchy of claims in bankruptcy proceedings.

DHFL resolution

    • Its loan book looks largely healthy, especially its mortgage lending section. 
    • Buyers have shown interest in these assets and the insolvency process is expected to draw more. 
    • Bondholders and banks have their credit secured by underlying assets.

Challenges

    • Fraud – KPMG has flagged fraudulent transactions that could add up to about half the exposure banks have to DHFL. 
    • Writing off – If these charges are substantiated, banks may have to write off their loans to the mortgage lender. It would complicate any resolution plan involving a swap of debt for equity.
    • Possible attachment – DHFL is being investigated by the Enforcement Directorate on charges that could result in the attachment of its assets. This would make it tougher for resolution. 
    • If its insolvency resolution fails, India may have to subject its shadow banking industry to the same mechanism. 
    • Moody’s – Recently, the credit rating agency Moody’s Investors Service has flagged stress among non-banking financial companies as a key risk to India’s growth outlook.

 

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