Demonetisation is not a ‘monumental blunder’. It has fulfilled its objective – to garner people’s money into the banking system. In one month, almost all the demonetised currency notes in the country were back in bank vaults. This is corroborated by RBI governor Urjit Patel’s assertion that “the decision was not taken in haste but after detailed deliberations“.

The issue is that customers are unable to withdraw even the sanctioned Rs 24,000 per week from bank branches, and ATMs are still running dry. Despite assurances of adequate supply, the RBI has ploughed back only Rs 4.61 lakh crores of new currency back into the system whereas, on December 7, 2016, more than Rs 11.55 lakhs of the old currency notes have been deposited into bank branches. The RBI has made no commitment as to when the restrictions on withdrawal of cash will be removed.

The shortage of cash is a matter of great inconvenience for the public – and a source of political anxiety for the ruling party. But might it actually be deliberate government policy to keep the public cash constrained?

In what follows, I will assume that the restrictions on deposit withdrawals continue and that banks will thus be able to use the increased deposits to enhance lending and profitability.

In the customary pre-budget meeting on December 20, 2016, finance minister Arun Jaitley remarked , “The current financial year is not a conventional year as many major reformative decisions have been taken during the year. There is a need for out of box thinking as a series of steps are required about what the government can do and what the banks can do”. At this meeting, bankers sought full tax exemption for the provisioning of non-profit assets (NPAs) and public sector banks highlighted the need for recapitalisation. So, could demonetisation end up being part of the larger out-of-the-box reforms of the Indian banking system?

It is no secret that the banking system is under financial stress – particularly public sector banks. Banks are straddled with enormous NPAs. The IMF 2016 report highlights the share of public sector banks stressed assets – NPAs plus restructured assets – increased from 12.9% to 14.1% of total advances in the year to September 2015, while only around 40% of NPAs (6.2% of total advances at end-September 2015) are, on an average, provisioned against. S.S. Mundra, deputy governor, RBI, also pointed out, “The stressed advances to gross advances ratio as on June 2016 stood at 12%. The net profit as on March 2016 reduced to Rs 32,285 crores from Rs 79,465 crores as on March 2015. During the same period, the return to total assets reduced from 0.78% to 0.29%.”

The declining profits are indicative of the persistent efforts by banks in the last two years to recognise the extent of irrecoverable loans. Simultaneously, banks are undertaking fresh initiatives to liquidate bad loan accounts. The government too is keen to facilitate this process of recovery from defaulting borrowers. The new Insolvency and Bankruptcy code was notified on May 28, 2016.

Effectively, demonetisation has ensured that the cash lying outside the banking system (given our predominant cash economy and the parallel black economy) is now within the banking system, in the accounts of the customers to whom it belongs. The government campaign on digital payments is ensuring that banks remain flushed with liquidity. Liquidity implies that banks can keep a small ‘fraction’ of the deposits as reserve, and lend out the rest to credit-worthy borrowers. However, credit off-take is likely to be slow since it will take time for the demonetisation hit economy to take off. It will take a long time for the banks to make profits that can completely wipe out the losses on account of NPAs. In the coming year, as banks net their losses, there will be greater clarity about the exact amount of fresh capital required by banks. The State Bank of India is already working out the scheme of a merger with its five associate banks subsequent to the cabinet approval in June 2016.

This brings us to the next logical question – where will this fresh capital come from? There are many options – equity shareholders of the bank can invest further into the bank, the government can provide fresh capital, weak banks can be merged with strong ones, or in the worst case scenario, a bank can be declared insolvent (central government is empowered to declare state-owned or nationalised banks insolvent). However, it is not easy to find an investor for a failing bank. In case of liquidation, there are established principles regarding the priority in which losses are borne –secured creditors get the best deal, the unsecured creditor also bears the brunt of failure but the equity shareholders bear the maximum loss.

Perspective from international finance

In 2008, the global bank crises threatened the very existence of the financial system. Simultaneously, the outcry against ‘bail outs’ using public funds gained momentum. There could be no rational justification for the government to tide over irresponsible banks. Since then, there has been a sea change in the collective thinking of central bankers all over the world. The Financial Stability Board (FSB) was set up in 2009 to ensure that banks never fail. It believes that a failure of banks destabilised the financial system and hence banks must never be allowed to fail. India, as a part of the G-20 group at the Brisbane summit in 2014, endorsed the FSB proposal ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’ that recommends ‘bail in’ to ensure the stability of the financial system. The first test run of the bail-in strategy for insolvent banks was launched in Cyprus in 2013.

India does not have the complete legal architecture necessary to implement this new international standard. However the committee set up by the finance ministry to draft the Financial Resolution and Deposit Insurance Bill 2016 submitted its report on September 21, 2016.

The report acknowledges “the committee studied guidances issued by the financial stability board and to the extent suitable, drafted the Bill to be consistent with the key attributes given in those guidances.” It envisages the setting up of a Financial Resolution and Deposit Insurance Corporation (FRDIC) that have the objectives of contributing to the stability and resilience of the financial system, protecting consumers up to a reasonable limit and protecting public funds, to the extent possible.

In case a bank “reaches the stage of imminent risk to viability” the FRDIC will have, amongst other things, the power “to exercise any of the tools to resolve the firm – sale to another financial firm, the incorporation of a bridge institution, or bail-in”.

‘Bail in’ and the unsecured depositor

On the face of it, setting up the FRDIC appears harmless enough – a mere streamlining and simplification of existing procedures. In reality, it aims to reorient the role of the RBI from supervision and regulation to financial stability. Since the primary concern will be financial stability, the fiduciary responsibility of the RBI, presently endowed under the RBI Act 1934 to protect the depositor, is automatically curtailed. The RBI would be taking the path trodden by other central banks in the world who have sacrificed the interests of the depositors in favour of fellow banks and corporates.

The mechanism of ‘bail in’ is recommended when a bank has failed, but it must be saved since its services are considered necessary. Under the FSB proposal, the resolution authority also has the power to impose a moratorium and suspend payments to unsecured creditors. In simple terms, this means that the money belonging to the unsecured and uninsured creditor can be used to save a bank from bankruptcy. The failing bank can be recapitalised with depositors money and without their consent as well. The new enactment grants sweeping powers to the resolution corporation.

When we deposit money in a bank – seldom do we think of ourselves as creditors. In fact, we are unsecured creditors of the bank. In case a bank fails, we would lose our deposit because the bank does not give us any tangible security against this deposit. However, in India, the Deposit Insurance and Credit Guarantee Corporation insures our deposits to a maximum of Rs 100,000 per deposit account in a bank. So, if a customer has a deposit of Rs 150,000 in his bank account and the bank fails, then the excess of Rs 50,000 is uninsured and the customer has no legal remedy to recover this amount.

The resolution regime

If the draft Financial Resolution and Deposit Insurance (FRDI) Bill 2016 becomes law, it would create a ‘resolution regime’ that would hurt all bank deposit account holders, even those with legitimate money – pensioners, home-makers, self-employed small business people, service providers such as domestic help, plumbers, electricians, carpenters and so on who have put their lifetime of savings in banks. This is a double whammy. First, banks use depositors funds to disburse loans without proper due diligence. Then, in case of defaults by the borrowers, the depositor is expected to make good the losses on account of the bank-business nexus.

A cause for serious concern is the August 2016 FSB progress report on the ‘Implementation and Effects of the G20 Financial Regulatory Reforms‘. It concludes that in some countries (including India) there are gaps in the powers of bank resolution regimes. It further adds, “By December 2016, jurisdictions will report to the FSB what actions they have taken, or plan to take (including implementation time frames) to address these gaps.”

The FRDI process may well be occurring independently of the sudden decision to demonetise but the chaos generated by demonetisation provides a cautionary pointer. While there can be no dispute about being free from the evil of ‘corruption and black money’ or embracing a new ‘digital’ technology that is fast changing the way we live, the only fear is that the continuation of the restrictions on cash withdrawal could signal the onset of a ‘bail in’.

As we wait for the December 30, 2016 deadline for the demonetisation process to be completed, there are vexing questions that require answers. Has a surreptitious beginning been made towards the recovery and resolution of financial institutions? During 2017-19, some unviable banks in the Indian banking system are likely to be liquidated and others merged with bigger ones but more importantly, will the ‘unaware’ uninsured depositors pay for it? Is it now time for ‘caveat depositor’? As a nation, must we follow international diktats that hurt the trusting bank customer instead of punishing the wilful defaulters, errant banks and even the negligent regulator?

Meera Nangia’s doctorate was on the Indian banking system. She is working as an associate professor in commerce at the University of Delhi.

Note: The article was updated on December 29 to make its key assumption – that restrictions on cash withdrawals from the banking system will continue for some time – explicit.