Resolution regime needed for financial sector entities

By Sawant Singh and Aditya Bhargava, Phoenix Legal
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Following the Insolvency and Bankruptcy Code, 2016, which applies to individuals and non-financial entities, the Financial Resolution and Deposit Insurance Bill, 2017, aims to provide a resolution regime for financial sector entities. The bill was introduced in parliament in August, and currently is pending examination by a joint committee of parliament.

Sawant SinghPartnerPhoenix Legal
Sawant Singh
Partner
Phoenix Legal

The bill applies to all “specified service providers”, defined as banks, financial institutions, insurance companies, payment systems, holding companies of specified service providers, and unregulated entities in corporate groups providing financial services, including a “systemically important financial institution” (SIFI) and the Indian branches of overseas bodies corporate. The last is a welcome addition as it addresses an oft discussed legal grey area and the impact of a cross-border insolvency on Indian depositors.

The bill proposes to establish a “resolution corporation” (RC) to ensure orderly liquidation and resolution of troubled financial sector entities. The RC would have powers such as search and seizure and the power to enter premises of specified service providers in certain cases.

The bill is the first in India to provide for the designation of SIFIs, based on factors such as size, complexity, nature and volume of transactions with other financial service providers, and interconnectedness with other financial service providers. SIFIs are required to provide a “resolution plan” and a “restoration plan” within 90 days of designation as a SIFI. A resolution plan must identify assets and liabilities, contingent liabilities, critical functions, direct or indirect access to financial market infrastructure services, and any strategy to exit a resolution process. A restoration plan must identify assets and liabilities, contingent liabilities, steps to achieve a lower risk classification, and timelines for implementation of the plan. Resolution plans and restoration plans are required to be revised annually.

Notably, the bill also requires specified service providers that are not SIFIs but have been identified on the basis of prescribed risk criteria to provide a resolution plan and a restoration plan within 90 days of such identification. The risk grades prescribed are: low (where the probability of failure is substantially below the acceptable probability of failure); moderate (where the probability of failure is marginally below or equal to the acceptable probability of failure); material (where the probability of failure is marginally above the acceptable probability of failure); imminent (where the probability of failure is substantially above the acceptable probability of failure); and critical (where the probability of failure is substantially above the acceptable probability of failure, and the entity is on the verge of failing to meet obligations to its consumers).

Aditya BhargavaPartnerPhoenix Legal
Aditya Bhargava
Partner
Phoenix Legal

To ensure orderly liquidation or resolution of financial sector entities and protect and preserve the interests of depositors, the bill grants the RC the power to consider various means for the resolution of a specified service provider, such as transferring its assets and liabilities to another person, merger or amalgamation, “bail-in”, or liquidation.

The “bail-in” provisions have drawn considerable flak. Section 52 of the bill indicates that the intent of a bail-in is “to absorb the losses incurred, or reasonably expected to be incurred, by the specified service provider and to provide a measure of capital for it so as to enable it to carry on business for a reasonable period and maintain market confidence”.

Section 52(3) of the bill defines a bail-in provision as: a provision cancelling a liability owed by a specified service provider; a provision modifying, or changing the form of, a liability owed by a specified service provider; or a provision that a contract or agreement under which a specified service provider has a liability is to have effect as if a specified right had been exercised under it. Section 52(7) of the bill provides that a bail-in instrument shall not affect any liability owed to a depositor to the extent of deposit insurance, any liability owed due to the holding of “client assets”, or any secured liability. While the term “client assets” is yet to be defined, presumably it would include funds of depositors.

The bill makes laudable efforts – in line with global best practices – such as recognizing branches of overseas companies as specified service providers and proposing a framework for the orderly resolution of SIFIs to avoid a recurrence of the 2008 financial crisis and the “too big to fail” phenomenon. Public criticism of the bill has largely been focused on controversial provisions and not the bill itself.

While some provisions can be revisited in light of the joint committee’s feedback, it would be optimal for the Indian financial sector if the bill is enacted as soon as possible.

Sawant Singh and Aditya Bhargava are partners at the Mumbai office of Phoenix Legal.

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