What is resolution regime?

Budget 2016-17 had introduced a resolution regime for financial institutions including banks when they face financial distress. Resolution regime is the bankruptcy code for banks. Banks are unique institutions and hence a usual bankruptcy code applicable for a corporate will not be usable for banks.

The resolution regime is a child of the financial crisis of 2007 and it helps the economy to settle a failed bank without using money of the public and at the same time by avoiding any systemic trouble.

When a bank fails, it creates two important outcomes: first, banks should be rescued by using tax payer’s money. Second, it may leave a vacuum in the financial market.

Resolution regime is a government created legal framework that resolves a failed bank in an orderly way so the financial markets do not collapse.

“Resolution” here indicates an orderly resolution of distressed financial firms without taxpayer’s support.

The resolution regime provides mechanisms and guidelines for an orderly management of the distressed bank’s affairs either by reconstructing it or by liquidating it- but without using public money.

Emergence of resolution regime

One of the man lessons of the global financial crisis of 2007 was that banks were taking too much risk. They knew that as a result of extreme risk taking and if failure happens, government or central bank will come for its help.

Such awareness has encouraged bank CEOs to acquire more risks. When they take high risks, banks may fail as happened during the financial crisis.  Here, governments bailouts banks using public money (taxes).

This situation is called moral hazard problem. Banks takes too much risk to achieve growth at the same time knowing that government will bailout them if they fails.

After the financial crisis, different efforts were made to break this moral hazard problem.

The best way is to convince the banks that nobody will come to their rescue if they fail. Similarly, banks should have large capital or own money to finance their rescue. Hence, the Basel norms instruct banks to keep more capital. Another mechanism was the resolution regime.

What is resolution?

Resolution is the State’s power to resolve a failed bank in an orderly way so the financial markets do not collapse. Under this mechanism, banks should prepare a plan for their reconstruction or liquidation if they face stress.

Prior to the crisis, most governments lacked resolution powers, leaving liquidation (end of the bank) or bail-outs (restructuring them) as the only options.

The resolution powers are sale, bridge (a new entity to separate out good and bad assets) or recapitalisation. A recap (or a ‘bail-in’) is converting the bank’s debt to equity, just like in a corporate restructuring.

Living Will in the US

The resolution regime in the US is named as living will. A living will denotes a contingency plan that is prepared by a bank when it becomes insolvent (failure) and needs to be closed, sold and/or broken up. Banks often called the resolution regime as a ‘funeral plan’ for them.

Resolution Regime in India

Budget 2016-17 has introduced a resolution regime in India for banks that is different from the proposed bankruptcy regime. Earlier, a Working Group was set up under the direction of the FSDC Sub Committee on a comprehensive resolution regime for all types of financial institutions in India.