India bank's ambitious resolution framework to face major hurdles

Appetite for reforms still unclear, says Fitch.

Draft proposals, published on 2 May, for a comprehensive Indian financial institution resolution regime may face major implementation risks, says Fitch Ratings.

Here's more:

Furthermore, we would review our support assumptions for some classes of bank liabilities if the regime is successfully implemented with a strong political commitment to impose losses on wholesale creditors in the resolution process.

The proposals, prepared by a Reserve Bank of India (RBI) working group, are ambitious in scope and part of a larger international effort to draft new resolution frameworks by end-2015. These frameworks are being designed to address moral hazard risks posed by systemically important financial institutions (SIFIs), and establish transparent and sustainable policy regimes to resolve problem and non-viable institutions.

We believe that the recommendations will move India toward international best practices. However, the proposals are likely to face significant implementation challenges at both the legislative and political level.

The creation of a single Financial Resolution Authority (FRA) and adoption of new resolution policies such as a proposed "bail-in" mechanism will require comprehensive changes to the legislative framework. The recommendations to equally apply the regulations to public and private institutions, are likely to prove particularly challenging to implement from a political perspective.

Nearly 75% of bank assets in India are held in state-owned institutions, and this is a factor which contributes to depositor and creditor confidence. India is still largely an under-banked country (private credit-to-GDP of around 53%), and financial inclusion remains an important political objective. 

As such, it is unclear whether there is appetite for reforms that would change the government's role in the financial system and create a structure that would potentially allow for more bank failures.

India currently lacks a comprehensive policy framework for financial institutions. Resolution powers are limited and scattered across several regulatory bodies, creating ambiguities and gaps for certain categories of banks.

At the core of the proposed framework is the creation of the FRA - a unified and independent regulatory body with an exclusive legal mandate for all financial institution resolutions. The FRA would not explicitly distinguish between state-owned and private SIFIs in the resolution process, thus ensuring equal treatment of both public and private banks.

The framework also recommends the creation of a bail-in system that could include some senior creditors. If implemented with a strong level of political commitment, this may cause Fitch to review its ratings assumptions for various classes of liabilities, and the high level of government support currently factored into systemic and state-owned institutions.

The proposals do, however, also recognize the risks of financial instability that may be caused by a bail-in, and aims to protect depositors by ensuring equal treatment for both insured and uninsured depositors (together with inter-bank and short-term debt liabilities). Furthermore, the framework ranks depositors' claims ahead of senior bondholders.

Hybrids and subordinated capital instruments will be bailed-in at the early stages of the waterfall. This will contribute to reducing the level of moral hazard in such instruments, and may lead to higher wholesale funding costs for Indian financial institutions.