India's bank resolution plans fraught with political obstacles: Fitch

It may be difficult to generate political support for the potential overhaul.

A new draft bill has brought India one step closer to creating a financial institutions resolution framework that includes an option to bail-in senior creditors. However, a strong political consensus will be required if the plan is to be implemented in its current form, says Fitch Ratings. The lack of a specified timeline suggests its passage is not an immediate priority, and policymakers are likely to be wary of any changes that might make it more difficult for banks to attract funding.

Here's more from Fitch Ratings:

India currently lacks a comprehensive policy framework to deal with the failure of financial institutions. Resolution powers for the financial sector are limited and scattered across several regulatory bodies. The draft bill aims to create an independent Financial Resolution and Deposit Insurance Corporation (FRDIC) with responsibility for a wide range of financial institutions.

The framework is largely in line with recommendations made by a Reserve Bank of India (RBI) working group in 2014. It is also in keeping with international efforts to improve resolution mechanisms, and follows the passage earlier this year of a bankruptcy law for non-finance companies in India.

However, the bill is likely to face obstacles in parliament. The governing acts of various public-sector entities would need to be amended to give the FRDIC sufficient powers to perform this role. Fitch believes it may be difficult to generate political support for such an overhaul.

Under current law, public banks cannot be resolved without government permission. The RBI has historically used mergers as a resolution mechanism in the banking sector, with losses imposed only on shareholders. Any perceived weakening of state support could weaken creditor and depositor confidence, creating funding risks for public banks - which account for nearly 75% of bank assets and are key to the politically important objective of increasing financial inclusion.

The option to bail-in senior creditors is likely to be particularly contentious. It would see senior creditors effectively ranking below depositors, instead of pari passu. This distinction would reduce the moral hazard that has developed around the assumption that government support will protect creditors from losses at different levels of the capital structure.

However, the risk of senior debt bail-ins could have market access and pricing implications for banks' future bond issuance at a time when their financial positions are already fragile. Appetite for bank AT-1 capital instruments could also be affected to the extent that investors view the government as becoming more willing to allow them to take losses. Banks already face a significant challenge in making up large capital shortfalls over the next couple of years.

If the draft bill is passed in its current form, its wording indicates that the strong preference will still be for regulators to work toward returning financial institutions to health. Bail-ins and liquidation will be a last resort, with the FRDIC only becoming involved at a late stage, after efforts to revive the institution had not worked as planned.

In practice, this suggests there will be a strong likelihood that the FRDIC would only be willing to apply to bail-ins to small, private, non-systemic banks. Fitch will not be reviewing its support ratings assumptions for Indian banks until there is greater clarity on the final framework and how it will be used.