India’s financial markets need more depth for US-style bank bailouts

The California Department of Financial Protection and Innovation took over the troubled bank and placed it under the receivership of the Federal Deposit Insurance Corporation (FDIC). The FDIC invited bids for the California-based lender, and regional banks – including PNC Financial Services Group Inc, Citizens Financial Group Inc and Fifth Third Bancorp – submitted bids.

In the end the FDIC chose the bid by JPMorgan Chase, America’s biggest lender, as it entailed the lowest cost to the regulator. Once JPMorgan takes over all of First Republic’s deposits and most of its assets, the FDIC will sustain a loss of some $13 billion and extend a loan of $50 billion to JPMorgan to tide over the acquisition.

Banks in the US, as in most places, do not have the same insolvency process as non-financial companies. Regulators intervene to insulate the financial system from systemic damage. Silvergate Bank shut voluntarily in March, brought down by its huge exposure to the cryptocurrency ecosystem and the collapse of crypto exchange FTX.

Silicon Valley Bank and Signature Bank failed in rapid succession, primarily because they failed to update the maturity profile of their investments and deposits while the Fed was hiking interest rates at record pace. The long-term government paper in which the banks had invested a portion of their deposits dropped sharply in value as interest rates rose. When depositors panicked in the wake of Silvergate’s self-liquidation and started shifting money from smaller banks to larger ones, the banks could not pay depositors seeking their money back by selling these depreciated assets.

The Trump presidency diluted the regulatory and supervisory norms for US smaller banks, which allowed problems at these banks to fester. These dormant problems were triggered when interest rates rose sharply over the course of a year.

What is striking in the resolution of First Republic Bank’s failure is the attempt by US banking regulators to let market forces function in the resolution process. Regulators took over the bank when its fall seemed imminent, true enough, but sold it after writing down its equity and debt to zero, and then inviting bids for the bankrupt entity. The FDIC needed to take on some of the losses on the bank’s assets, and chose the bid that would minimise these losses.

This is in contrast to what the Reserve Bank of India (RBI) did, for example, in the case of Yes Bank and Laxmi Vilas Bank, both of which were restructured and placed under new management at the regulator’s discretion (LVB was sold to the Indian subsidiary of Singapore-based DBS) rather than through a formal, market-based process. Swiss authorities, too, arranged for UBS to take over the troubled Credit Suisse through its privileged access to bank managements rather than a market-based process.

The bottomline is that regardless of the model of intervention, further contagion was averted and minimal disruption created for stakeholders. Of course, holders of Yes Bank’s Additional Tier 1 (AT1) bonds are disgruntled, their bonds having been written off while equity was not.

The truth is that AT1 bondholders’ grouse is based on confused terminology. AT1 bonds are bonds only in name. They are a form of insurance against a bank’s collapse, meant to be written off before it gets into serious trouble. They are similar to catastrophe bonds that re-insurers issue to create a payment pool in case a disaster, against which insurance has been sold, does strike.

Investors know they get a higher rate of return on these bonds only because they risk being written off in full or in part in case a catastrophe does occur. Credit Suisse’s Additional Tier 1 bonds were also written off in full before it was sold to UBS while its equity remained, albeit at a fraction of its previous value.

Uday Kotak commended the manner in which JPMorgan took over First Republic Bank and urged India to have such well-funded domestic banks to play a similar role during crises. Fair enough. India makes up for a lack of depth in financial markets with regulatory activism. But deepening the financial markets is the only way to ensure there are market-based solutions to financial problems.