16 March 2023

Table of Contents

What are Too-Big-To-Fail banks

GS-3: Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment

During the 2008 global financial crisis, India was a secure place to invest, as domestic banks demonstrated strength and resilience due to their robust regulatory practices, despite the collapse of Lehman Brothers investment bank.

Even after fifteen years, Indian banks remained unharmed by the recent failures of Silicon Valley Bank (SVB) and Signature Bank in the US, indicating their resilience and independence from global financial interconnectedness.

Understanding the Foundation of Confidence in the Resilience of Indian Banks

• Bankers in India have stated that it is unlikely for an SVB-like failure to occur in India due to the different balance sheet structure of domestic banks.
• In India, the majority of bank deposits come from household savings, unlike in the US where a significant portion is from corporates.
• Public sector banks hold a large chunk of Indian deposits, and the rest is with strong private sector lenders like HDFC Bank, ICICI Bank, and Axis Bank.
• The banker reassures customers that the government has always intervened to protect banks that have faced difficulties. The failure of SVB did cause concern in the stock markets, but regulators and the government stepped in to calm the markets and protect depositors' money.
• Confidence is crucial in banking and regulators in India have always aimed to protect depositors' money.

Classification of banks as domestic systemically important banks (D-SIBs)

• SBI, ICICI Bank, and HDFC Bank have been designated as D-SIBs by the RBI, and they have to set aside additional capital and provisions to safeguard their operations. 

• The additional Common Equity Tier 1 (CET1) requirement was phased-in from April 1, 2016 and became fully effective from April 1, 2019.

• The RBI was required to disclose the names of D-SIBs from 2015 and place them in appropriate buckets based on their Systemic Importance Scores (SISs).

The process for RBI to identify D-SIBs

• The RBI assesses the systemic importance of banks using a two-step process.

1. A sample of banks is selected for assessment based on their size (based on Basel-III Leverage Ratio Exposure Measure) as a percentage of GDP, with only banks above 2% of GDP being considered.
2. A detailed study is conducted to compute a composite score of systemic importance for each bank in the sample.

• Banks with a systemic importance score above a certain threshold are designated as D-SIBs.
• D-SIBs are then segregated into buckets based on their scores and subjected to a graded loss absorbency capital surcharge.
• The amount of capital charge depends on the bucket in which the D-SIB is placed, with higher buckets attracting a higher capital charge.

• The Basel, Switzerland-based Financial Stability Board (FSB), which is an initiative of G20 nations, has identified 30 global systemically important banks (G-SIBs) in consultation with the Basel Committee on Banking Supervision (BCBS) and Swiss national authorities, but no Indian bank is on the list.

The significance behind establishing SIBs

• The 2008 crisis resulted in problems faced by large and interconnected financial institutions that disrupted the global financial system and negatively impacted the real economy. Government intervention became necessary for financial stability.
• The RBI suggests that future regulatory policies should aim to reduce the probability and impact of SIBs failing to avoid the high cost of public sector intervention and increase in moral hazard.
• In 2010, the FSB recommended that all member countries implement a framework to reduce risks related to SIFIs (systemically important financial institutions) in their jurisdictions.
• SIBs, perceived as 'Too Big To Fail,' enjoy certain funding market advantages, but this perception encourages risk-taking, reduces market discipline, creates competitive distortions, and increases the probability of future distress.
• The RBI suggests additional policy measures should be imposed on SIBs to guard against systemic risks and moral hazard issues.

• While the Basel-III Norms require a capital adequacy ratio of 8%, the RBI has mandated a higher CAR of 9% for scheduled commercial banks and 12% for public sector banks.

The rationale behind taking these precautions

• A large bank's failure can cause contagion effect globally.
• A significantly large bank's impairment/failure can cause greater damage to the domestic real economy and damage confidence in the banking system as a whole.
• Size is the most important indicator of systemic importance. The failure of one bank can increase the probability of others' failure due to high interconnectedness. This chain effect operates on both sides of the balance sheet — there may be interconnections on the funding side as well as the asset side.
• A bank's role as a service provider in underlying market infrastructure can affect the disruption caused by its failure.
• Customers of a failed bank may incur higher costs for the same service at another bank if the failed bank had a greater market share.

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Fact File