India has now three too-big-to-fail banks, an idea that sprang from the lessons of the global financial crisis and which the Reserve Bank of India (RBI) adopted to follow global best practices.
RBI included HDFC Bank Ltd in its latest updated list of domestic systemically important banks that have a balance sheet size of more than 2% of gross domestic product (GDP), are complex, interconnected with almost all players of the system and cannot be substituted by any other entity.
These banks are subject to greater scrutiny than their peers and will need to set aside higher capital because the inclusion in this big-boys club gives a perception of an implicit support from the regulator and the government. In other words, should they slip into deep trouble, the government would do whatever it takes to keep them afloat.
That begs the question: do governments allow banks to fail? Does this mean that banks other than the big three (State Bank of India and ICICI Bank Ltd being the other two) would be allowed to perish?
There is enough evidence that RBI and the government will never allow a bank to wind down irrespective of ownership and size. Recall the cases of Global Trust Bank and many small cooperative banks in the past that were merged with stronger banks but never allowed to wind down. To be fair, their shareholders got a hit but depositors were protected.
Even in the current case of toxic loans, the government has now begun talking about consolidation of public sector banks, well aware that many lenders are just the walking dead of the system. They have no credit growth to show and their impaired assets are higher than their net worth. In a hypothetical case of the capital of these banks being wiped out by surging bad loans, it is expected that lenders would be merged instead of being wound down.
This is not just the case in India. Globally too, sovereigns seldom allow banks to fail. Following the financial crisis, the UK government had to step in to save the banks there and spent over £100 billion to rescue Lloyds Banking Group and the Royal Bank of Scotland.
Jayanth Varma, professor at Indian Institute of Management Ahmedabad, wrote in his blog that policymakers are picking winners and losers, and making the subsidy available to the too-big-to-fail entities certain.
Internationally, regulators are realizing that this implicit guarantee of rescue available to the too-big-to-fail banks is unfair. Indian policymakers need to treat banks like corporations, allow them to own up past missteps and in the case of extreme distress, allow them to die.
