Reserve Bank of India (RBI) has included HDFC Bank in the list of 'too big to fail' lenders. With the inclusion of HDFC Bank in the list, there will now be three 'too big to fail' financial entities in the country.

HDFC Bank joins India's largest lender SBI and private sector major ICICI Bank who joined this list back in 2015.

What does ‘too big to fail’ mean

When a financial entity like a bank becomes systemically so important that their failure is expected to disrupt the financial/banking system and the economy as a whole then that entity is termed as ‘too big to fail’. In an event that such a bank fails the government steps in to save it.

The phrase has been used in the media on several occasions in the past but it was more discussed during and after the global financial crisis in 2007-2008 that saw banks with expansive portfolios collapse which affected economies around the world.

RBI categorises such banks as Domestic Systemically Important Banks (D-SIBs). RBI, in its framework for dealing with D-SIBs, describes them as “banks [that] assume systemic importance due to their size, cross-jurisdictional activities, complexity, lack of substitutability and interconnectedness. The disorderly failure of these banks has the propensity to cause significant disruption to the essential services provided by the banking system, and in turn, to the overall economic activity. These banks are considered Systemically Important Banks (SIBs) as their continued functioning is critical for the uninterrupted availability of essential banking services to the real economy.”

How does RBI identify a 'too big to fail' bank

Through a two-step process, RBI first creates a sample of banks that mostly includes larger banks. This sample, as per RBI, excludes smaller banks as they “would be of lower systemic importance and burdening these banks with onerous data requirements on a regular basis may not be prudent”.

After the sampling for D-SIBs, all the shortlisted banks go through a detailed study based on a range of indicators to devise a composite score.

These indicators are: size, interconnectedness, lack of readily available substitutes or financial institution infrastructure and complexity.

Later, banks having systemic importance above a threshold are decided and segregated as D-SIBs into different buckets.

This assessment methodology, followed by RBI, was prepared by the Basel Committee on Banking Supervision (BCBS) as a result of multiple measures that the global economic fraternity took to prevent worldwide economic crises in the future.

RBI has however made several changes to the BCBS methodology to suit the Indian markets and Indian economic scenario.

What does it mean for the banks

Apart from protection from the RBI in the times of distress, the D-SIBs will be subjected to higher levels of supervision so as to prevent disruption of financial services in the event of any failure.

These banks will have to maintain a core capital requirement in addition to a capital conservation buffer.

Industry experts say that expectations of government support amplifies risk-taking, reduces market discipline, creates competitive distortions and increases probability of distress in future.

(With inputs from PTI)