India has proposed the formation of a Financial Regulation Authority that will change the rules of insolvency settlement of banks and financial institutions by giving preferential right of payment to depositors over creditors. The move is expected to bring the functioning of the country’s financial systems closer to  international norms.

Even though the new framework will give a greater degree of protection and comfort to depositors, according to Kumar Saurabh Singh, associate partner at Khaitan & Co, “it is more focused on boosting the overall health of India’s financial institutions by strengthening the significant ones and at the same time, allowing the weaker ones to fail in a contained and a safe manner.”

This is despite the fact that Indian authorities have never allowed a commercial back to become insolvent. In last 10 years, nine banks in India were amalgamated with other banks and three were forced to merge.

India’s financial sector’s institutional framework consists of five agencies with clear mandates and allocation of powers. These are the Reserve Bank of India, the Insurance Regulatory and Development Authority, the Securities and Exchange Board of India, the Pension Fund Regulatory and Development Authority and the Forward Markets Commission.

However, according to Amarchand Mangaldas partner Sandip Beri, none of them are explicitly empowered by the law to maintain financial stability. “Considering the complexity attached to the process of resolution [of an insolvency situation], the need was acknowledged for a specialised institution to carry out activities related to it,” he says.

These activities, according to him, include the study of complex financial structures, assessment of interconnectedness and risk exposure, fast analysis of resolution options and implementation of resolutions, which are not the functions of sector-specific regulators.

According to Singh, the new centralised approach is likely to streamline the process and cut down on timelines and administrative difficulties. “The problem of dealing with financial conglomerates will also be taken care of to a large extent,” he says.

Expected to be functional by the end of 2015, the new authority will have its task well defined. As part of the exercise for its implementation and financial operations, several restructuring and liquidation tools have already been identified. According to Singh, the proposed framework contemplates substantial improvement in the current insolvency system, including faster reimbursement to depositors, provision of back-up funding to support shortfalls in deposit insurance fund, and technologically advanced data systems and payment methods.

The new framework recommends continuous regulatory oversight through a prompt corrective action. According to Beri, this mechanism will have several stages to determine the level of viability of a financial institution and the kind of coordination required between the new authority and existing regulators. “Timely and regular sharing of information between the relevant authorities is also important,” he says.

The new authority will have several quantitative and qualitative thresholds for determining the viability of a financial institution that would help in early identification of bad loans and risk exposure. “It will facilitate early intervention of sector-specific regulators by infusing additional capital, improving governance, strengthening systems and internal controls, and increasing regulatory reserves,” says Beri.

However, it would still maintain continuity of critical financial operations of the system, says Beri, and a temporary government takeover of a falling bank has not found favour. “It would be done only as a last resort,” he says. “This gives a signal that no public money will be spent to preserve a failing institution.”

The proposed framework suggests that the banks’ depositor fund will be maintained separately from  the resolution fund, and will be accessed by the new authority only in the event of resolution action and not during an early intervention, says Beri. Furthermore, “It will intervene only when a bank or a financial institution is already near insolvency.”

The new measures are going to bring along their own set of consequences. “It would potentially lead to higher wholesale funding costs for Indian banks,” says Beri, “this will also force credit rating agencies to review various classes of liabilities in the Indian market.”

With increased risks, investors are bound to demand a higher rate of interest and are likely to be more discerning. “The weaker financial institutions will find it difficult to raise funds from public debt markets,” says Singh, “They will either be pushed to improve performance or to eventually exit the market.”

According to Singh, the proposed framework will encourage Indian financial institutions to undertake recovery of bad debts with a more disciplined and focused approach.

The introduction of new resolution tools like a “bail-in mechanism” where liabilities of a financial institution are restructured by converting unsecured or subordinated debt into equity, will boost confidence in several hybrid and capital instruments, says Beri.

However, due to the provision of a late intervention of the new authority in a future insolvency situation, the absorption of the potential losses to investors on the subordinated debt will also be delayed, says Beri. “The power to trigger write-down clauses of subordinated debt lies with the new authority unlike other jurisdictions where it is controlled by central banks, which takes immediate steps for loss absorption whenever the minimum capital requirement is breached,” he says.

While the proposed framework does provide for judicial review of resolution actions or decisions taken by the Financial Regulation Authority, this cannot undermine the effectiveness of the entire process, says Beri.

The new authority, likely to have representation from other financial regulatory authorities, must engage in intensive coordination and cooperation with sector-specific regulators for making the whole process effective, he says.

From April this year, the Reserve Bank has started using a new regulatory framework for early detection and resolution of distressed assets. According to Beri, this system requires early recognition of stress in an institution and setting up of a repository of information for large credits whereby before an account is declared as a non-performing asset, it would pass through a “Special Mention Account.” Lenders falling under the framework will have to install a management information system for capturing immediate triggers, he says.

However, according to him, implementation of the new system is going to be a great challenge. “The creation of [a] new authority will require an altogether separate legal framework that overrides existing laws,” he says. “This might possibly come only after a parliamentary approval.”

Furthermore, Singh says that efforts to strengthen financial institutions without addressing the huge prevalence of bad debts in the economy would not yield desired results.

The Indian economy is estimated to have bad debts of about $50 billion in a $1.4 trillion banking system, and the problem in different banks and financial institutions are resolved by sector-specific authorities in accordance with their respective statutes.

Also, depositors in India are insured only for less than $2,000 compared to insured limits of $250,000 per person per bank in the U.S. and $39,965 in Singapore. At the same time, the recovery rate of bad debt in India is only 30 percent to 40 percent.

The new Financial Regulation Authority would only be one part of the whole process of running the system smoothly. “The government will have to take a very proactive role in addressing inherent systemic issues which give rise to bad debts in the first place,” says Singh.