Unless a resolution mechanism designed for a quick turnaround of stressed financial institutions is implemented, we will continue to lurch from one crisis to the next
The Reserve Bank of India (RBI) and the finance ministry have formulated a bailout plan for YES bank post-haste to prevent contagion in the financial system. Contagion usually results from a shock that generates uncertainty, which in turn causes a fear induced freeze in the financial system thereby initiating a self-fulfilling death spiral. This can only be combated by resolving uncertainty, which then restores confidence and allows market forces to operate freely. Unfortunately the RBI and the finance ministry plan tries to boost confidence without resolving the underlying uncertainty, and, in fact, even adding to it on some dimensions.
The recently approved plan envisages an equity investment into YES Bank by SBI and other private players, a write-down of Tier 1 bonds and a lock in period of three years for 75 per cent of the holdings of all shareholders except SBI. While the plan does nothing to address the root cause of this crisis that lies in the uncertainty around the true extent of losses hiding in YES Bank’s books, it creates several negative externalities for the system.
The plan hinges on its ability to convince depositors that YES Bank will remain a viable custodian of their funds after the restructuring. However, with no disclosure on the true extent of losses and ample signals that further equity investment may be required in YES Bank, it may be difficult to convince many depositors to continue to hold their funds in the bank. A flight of deposits from YES Bank post restructuring will further compound the problem and may create a large asset liability mismatch, which will require an even larger bailout. Thus, the plan in its current format is risky and deprives YES Bank of an opportunity to restructure its operations with a clean slate and restore the trust of its customers.
Second, the bailout plan creates massive uncertainty for providers of banking capital in the system. The plan preserves the value of equity at Rs 10 a share but writes down the value of Tier 1 capital while leaving Tier 2 capital (around Rs 18,000 crore) unscathed. This may be legally feasible, but is not backed by any economic logic. It is important to note that such a seemingly random allocation of losses among capital providers increases uncertainty for all classes of investors in banks (equity, Tier 1 and Tier 2) and not just Tier 1 investors as is being forecast. Investors in bank capital will now be worried that an arbitrary allocation of contingent losses may wipe them out completely while leaving other classes untouched. This will create uncertainty about the resolution process of failed banks and likely increase the cost of raising bank capital across the board and not just for Tier 1 bonds.
With no disclosure on the true extent of losses, it may be difficult to convince depositors to continue to hold their funds in YES Bank
Third, the decision to lock in shareholders for three years is loaded with negative signals. It shows that the authorities are unsure about the success of the plan. It also suggests that the new investors are uncertain about the true extent of losses on the books and wish to have downside protection on their investments (at least in the short run) should the losses be excessive or should the plan fail to stop a flight of deposits. Thus, instead of resolving uncertainty about YES Bank’s viability, it adds to it.
There are several other issues with the plan such as the fact that new investors are now on the hook for prospective losses on the legacy book while Tier 2 capital providers walk away scot free. Also the government has now provided a de facto blanket sovereign guarantee on all bank deposits irrespective of whether they have been made at private or state-owned banks. This means that depositors will have no incentive to examine and monitor the banks they deposit their money in. Moreover, managers of private banks now have a much weaker incentive to manage and minimise lending risk.
What is unfortunate is that this was not the only way to stem contagion. The RBI could have used the moratorium to completely write down the value of doubtful assets, offset the losses against equity, Tier 1 and Tier 2 capital and finally start to look for new investors with a clean slate and zero uncertainty. Alternatively, the dubious assets could have been housed in a “bad” bank supported by legacy equity, Tier 1 and Tier 2 capital while the deposits and healthy loans could be spun off into a “good” bank, which could have sought new equity investors without the overhang of uncertain losses. Both these solutions are based on sensible economics, alignment of incentives and reduction of uncertainty, compared with the current approach which is risky and perverts incentives in the financial system.
As this column has previously argued, what is missing from the current government’s policies is a commitment to structural reform. While western economies have realised the importance of orderly resolution of systemically important financial institutions and imposed pre-packaged resolution plans (see link for resolution plans of all major financial institutions in the United States, https://www.federalreserve.gov/supervisionreg/resolution-plans-search.htm) for large banks, we have been devoted to a make-as -you-go approach to financial regulation. Unless a resolution mechanism designed for a quick turnaround of stressed financial institutions is implemented in India, we will continue to lurch from one crisis to the next with patchwork solutions that may be worse than the problem.
The writer is a probabilist who researches and writes on behavioural finance and economics