A resolution framework mitigates the risks that could arise due to the failure of a bank. By clearly defining the safeguards, recovery and restoration processes, loss sharing mechanism, and ex-ante responsibility regime for any managerial misconduct, an effective process of resolution can reduce the risk of bank failures and can also limit their impact when they do occur. In the case of commercial banks, the too-big-to-fail phenomenon remains a key reason for putting in place an effective resolution mechanism. However, in the context of the Urban Co-operative Banks (UCBs), the need for an effective resolution framework goes beyond the too-big-to-fail phenomenon and hinges on the social cost, risk extenuation and execution aspects.

I. Introduction

Banks provide vital services to the people, businesses and the economy at large and are a critical component of the financial stability framework. A resolution framework through its preventative effects, a clearly defined ex-ante managerial responsibility regime, and public acknowledgement of its obligations in an unlikely event of failure or liquidity crunch is essential to making banks safer and less likely to fail and as such, forms an integral part of the financial stability edifice. It also ensures that banks do not take excessive risks and consequently it also minimises the moral hazard for the government and the regulator.

II. The UCB sector and the need for an effective resolution framework

The Urban Co-operative Banking (UCB) sector in India has traversed a long distance over the years. UCBs form an important vehicle for financial inclusion and have an important place in the financial system due to their local reach. However, the functioning of many UCBs is fraught with certain maladies. Governance remains a major challenge. Notwithstanding the quantum of funds involved, it is the social cost of bank failures which is important, and trust in the banking system receives a setback by the instances of bank failures, whether small or large. The High Powered Committee on the UCBs in its report dated August 20, 2015, had underlined the restricted ability of the RBI to regulate and supervise the UCBs at par with private sector commercial banks. Putting in place an effective resolution mechanism is a necessity to address the regulatory concerns and also for improving the governance standards. In the context of UCBs, at present, the resolution mechanism ensures pay-out to small depositors by the Deposit Insurance and Credit Guarantee Corporation (DICGC), but large depositors’ interests are not taken care of fully in the event of cancellation of the licence and liquidation of a financially unviable bank.

To read more, please subscribe.