INDIA's Financial Sector Legislative Reforms Commission (FSLRC) has recommended that the country must participate in global deliberations on developing a framework for cross-border resolution of weak global financial entities.

In its report to Finance Ministry last week, FSLRC notes that an effective resolution framework requires appropriate arrangements for cross-border resolution. Since many Systemically Important Financial Institution (SIFIs) operate on a global level, an uncoordinated approach by the home and host countries' authorities would create difficulties in the way of resolution of such institutions in a manner that would protect interests of consumers and prevent the risk of a contagion.

The report says that deliberations are underway at international policy forums to devise an optimal approach to cross-border resolution.

“India must participate in emerging global arrangements on cross-border resolution. The developments in this regard, in the coming years, may well require amendments to the draft Code on resolution - such as to require the resolution corporation to co-ordinate with its counterparts in other jurisdictions.”

The Commission has thus recommended that in five years from now, the Government should set up a committee to review the emerging consensus in the field of cross-border resolution and to suggest amendments in the Indian legal framework on resolution accordingly.

The report says: “The Commission recommends that the process of resolving a covered service provider including the choice of a resolution tool should not depend on the ownership structure of the service provider. This will result in ‘ownership neutrality' in the approach of the corporation.

In this framework, thus, the treatment of public and private firm; and domestic and a wholly owned subsidiary of a foreign firm will be identical from the viewpoint of resolvability.”

FSFRC has recommended setting up of a Resolution Corporation in the country to deal with stressed financial firms at early emergence of signs of trouble instead of letting their problems snowball into a crisis. Such crisis normally get tackled either through tax payer-funded bail-out of stressed financial service providers or through their bankruptcy.

Noting that private financial service providers have emerged significantly over the last 20 years following reforms, it points out that these firms can fail. And when this happens, it can be highly disruptive for households who were customers of the failing firm, and for the economy as a whole. Sound micro-prudential regulation will reduce the probability of firm failure. However, eliminating all failure is neither feasible nor desirable. Failure of financial firms is an integral part of the regenerative processes of the market economies: weak firms should fail and thus free up labour and capital that would then be utilised by better firms. However,

it is important to ensure smooth functioning of the economy, and avoid disruptive firm failure.

It contends: “This requires a specialised ‘resolution mechanism'. A ‘Resolution Corporation' would watch all financial firms which have made intense promises to households, and intervene when the net worth of the firm is near zero (but not yet negative). It would force the closure or sale of the financial firm, and protect small consumers either by transferring them to a solvent firm or by paying them.

It says: “At present, for all practical purposes, at present, an unceremonious failure by a large private financial firm in India is not politically feasible. Lacking a formal resolution corporation, in India, the problems of failing private financial firms are placed upon customers, tax-payers, and the shareholders of public sector financial firms. This is an unfair arrangement. Establishing a sophisticated resolution corporation is thus essential.”

According to the Report, if there is no resolution framework, the Government will be pressured to capitalize distressed firms, leading to high fiscal costs, and losses to tax payers. This is especially true in the case of a SIFI, whose failure could threaten financial stability and the health of the real economy. The other alternative to taxpayer-funded bailout could be bankruptcy.

However, as global experience in the aftermath of the financial crisis shows, regular bankruptcy proceedings may not be adequate to prevent financial market instability. Thus, a specialised resolution regime must offer a viable alternative to the financial instability resulting from bankruptcy proceedings, or the fiscal and political consequences of tax payer-funded bailouts.