India needs to reform the way it handles bank failures

That, to him, was the real threat to the regulators. Baer recognized that there was too much risk that was not fully understood by banking supervisors. That seems prescient now, as the US administration and regulators scramble to quickly douse the fire, calm depositors’ fears and avert a potential financial crisis from the failure of two banks this month.

The bank resolution process in the US is fast. This time, by classifying the two banks as systemically important, the US Treasury, Federal Reserve and other regulators ensured that even uninsured deposits were safe without a taxpayer-funded bailout. This may be done to deflect criticism and a possible wider fallout after claiming to have built more robust safeguards for the banking system following the 2008 crisis.

But the failed banks had a strong message for investors. President Joe Biden said Monday that he knowingly took risks and lost money, and therefore would not be protected. That’s how capitalism works, he said.

Try telling that to investors in banks like Lakshmi Vilas Bank (LVB), which was proposed to write off entire capital and reserves post merger following the RBI’s plan. Or for those in Yes Bank, whose shareholders had to settle for diluting their holdings after capital infusion by State Bank of India and a few other banks, which imposed a three-year lock-in.

In the past two decades, the standard recourse for the banking regulator and the government to protect depositors has been shotgun mergers with another lender, in most Indian bank failures. For depositors, with an initial limit on withdrawals, the wait can be excruciating. All the same, the RBI’s rescue plan ensured that losses on the equity holdings of Yes Bank’s promoters were subsidized by SBI.

Four years ago, efforts by the NDA government to reform the bank failure resolution process to ensure speed and efficiency on the lines of foreign resolution regimes had to be abandoned in the face of resistance. Government has been successful in raising the limit of insured deposits from 1 lakh 5 lakhs after decades. In contrast, US authorities are backstopping deposits and ensuring that even uninsured deposits at Silicon Valley Bank and Signature Bank are fully repaid.

It can be easy to pan US regulators and their oversight and perhaps take a high ground on regulation here. But this is an opportune time for India’s government and regulators to revisit the resolution process for failed financial firms, particularly banks.

This will include considering whether India needs a separate body like the FDIC to swiftly handle bank failures, rather than an RBI subsidiary like the Deposit and Credit Guarantee Corporation, which manages insurance of deposits.

This would also mean addressing other issues, such as different insurance premiums for banks with different risk profiles and higher cover for competing insurance firms and opening up, higher capital support for the Financial Solutions Corporation and politicizing the process , and making it fast and efficient, unlike the bankruptcy process for other firms. Obviously, given its concerns over financial stability and the fact that it supervises banks, the RBI will first have to be convinced it offers a far more credible approach.

There are stark differences between the way SVB and Signature Bank have handled the failures and the way some Indian banks have handled the failures. When the government and regulators here talk about the safety of banks and the safety of deposits, what is often overlooked is that unlike many other countries, a large group of Indian banks are controlled by the sovereign. This underlying guarantee actually prevents runs on banks, even when depositors and investors know that bad loans total 20% or more. The cost is ultimately borne by the taxpayer in the context of capital provided by the government and the continuing low return on capital employed.

As Barr said in his FT interview, there is a lot of bragging when banks are well capitalised. The former FDIC chief made that statement in his own backyard – the U.S. If the regulators and government of India also take a lesson from this, then surely it will not hurt.