Relevance: mains: G.S paper III: Indian Economy
Context
- The liquidity and solvency issues plaguing the non-banking financial sector continue unabated. Earlier this week, Dewan Housing Finance Corporation Ltd (DHFL) defaulted on its repayment obligations to the tune of Rs 1,571 crore.
- NBFCs/HFCs continue to struggle to repay their loan obligations and raise low cost funds.
- As credit flow through this channel has slowed down, the ripple effects are being felt in the broader economy.
Background
- One way, perhaps, to have contained the crisis, and prevent it from spreading throughout the financial sector, engulfing mutual funds as well, would have been through quick and orderly resolution/liquidation of firms in trouble.
- But the resolution framework, as it exists, makes it difficult to close down financial firms such as banks and NBFCs.
- The Financial Resolution and Deposit Insurance (FRDI) bill had envisaged a framework for this.
- The bill, which was introduced by the NDA government in its first term, however, was withdrawn due to protests over some clauses. The current situation warrants a fresh look at the legislation.
Challenges to the resolution/liquidation of financial firms
- The resolution/liquidation of financial firms is a challenging process, as, unlike in the case of non-financial firms, there are depositors to deal with.
- The inter linkages between financial firms and the broader economy complicate matters. The FRDI bill had envisaged the creation of a resolution corporation, endowed with powers to monitor/assess the risk of financial firms, to enable speedy resolution of firms — either through a merger or by selling off or winding up or through other avenues.
- As the events of the past few months show, there is a need for regulators to step in quickly.
- Delays in recognition and failure to act in time lead to higher losses. A long drawn out insolvency process for financial firms, as in the case of IL&FS, can have far-reaching ramifications for the economy.
- In comparison, an early resolution can lessen the impact of firm failure on the economy, and lead to more efficient allocation of capital.
Conclusion
- The FRDI bill was withdrawn due to protests over the contentious “bail-in” clause and concerns about the extent of deposit insurance.
- But, as the complications in the ILandFS resolution process and the ongoing problems in the NBFC sector show, the government would do well to bring it back, albeit with modifications to address the issues that have been raised.