For a law to resolve financial firms

For a law to resolve financial firms

Don’t let promoter sin prevent DHFL revival.

The reported stalling of attempted restructuring of Dewan Housing Finance Corporation (DHFL) following a probe ordered by the Serious Fraud Investigation Office into alleged improper advances in related party transactions in the housing financier’s bulk lending business points to the need to create a mechanism for resolving failing financial firms. The Financial Resolution and Deposit Insurance Bill that the government had introduced in the last Lok Sabha got dropped because of a public outcry over its proposal to ‘bail in’ ordinary deposits, that is, to use deposits as loss-absorbing capital. The political economy is against any proposal to make banks convert ordinary deposits, even if only those above a particular threshold, into quasi-equity that would be wiped out in case of trouble.

It would make more sense to ask banks to increase their loss-absorbing capacity by issuing special bonds that explicitly carry the risk of losing their principal in case of the issuer’s failure, and compensate the investor for such risk with a higher rate of return when things are normal. Non-banking finance companies (NBFCs) work with a lighter load of regulation as compared to banks and their deposits bear no insurance. It is simpler to work out a regime for their resolution, in case of failure, than it is for banks. However, while that is work not even yet begun, should the government allow a major NBFC like DHFL fail? The ideal solution should be to ring-fence the problematic loans and separate the promoters from the lender while the rest of the planned restructuring of ownership and control goes ahead, so as to allow the institution to not only survive but also have its loans serviced by its regular borrowers, enabling it to meet its obligations to its own creditors to some viable degree.

If the promoters are found to have played around with the NBFC’s funds, they should be penalised, but not the NBFC itself nor its creditors. Allowing another NBFC to go down, impacting banks and mutual funds that have lent to it, would not be in the interest of the economy.