A number of clients have written in asking for our comments on the “Bail In” clause mentioned in clause 52 of the Financial Resolution and Deposit Insurance Bill (2017) tabled before the Joint Parliamentary Committee in August this year. The “Bail In” clause gives power to a body called the “Resolution Corporation”” appointed through the powers of the said act to re-classify liabilities including fixed deposits of banks (excluding insured deposits, current accounts and the like). Re-classification can be in the form of a hair-cut to the principal, or a delayed payment with reduced interest or a conversion to some form of equity in the bank, to spruce up the balance sheet of the bank. Essentially the Government of India is offering banks a way to spruce up their balance sheets at the expense of fixed deposit holders through this “Bail In” clause as opposed to a “Bail Out” wherein external equity capital is pumped in (primarily by the Government of India in the case of Public Sector Banks).
The Indian fixed deposit investor has largely worked under the assumption that his bank fixed Deposits have a sovereign guarantee from the Government of India. Strictly speaking this has never been true and only deposits to the extent of only one lakh rupees have been guaranteed. Nevertheless this bill explicitly states that power be given to the Resolution Corporation to re-classify most bank liabilities including fixed deposits into a convenient form such that the bank under stress could spruce up its equity at the expense of holders of bank debt rather than resorting to external equity capital. While not wanting to get into the inherent fairness of such a bill, investors in Indian bank fixed deposits must realize that if this bill becomes an act there will be nothing “fixed” in the fixed deposit - neither principal nor interest.
To give investors a framework on how to think through the selection of fixed income securities it is prudent that we apply the timeless principles expounded by Graham and Dodd in their classic book “Security Analysis” on the selection of fixed income securities (chapter 22, p281 of the third edition). Graham and Dodd write with great wisdom the following four principles in the selection of fixed income securities which I will repeat verbatim :
1. Safety is measured not by specific lien or other contractual rights but by ability of the issuer to meet all its obligations.
2. This ability should be measured under conditions of depression rather than prosperity.
3. Deficient safety cannot be compensated for by an abnormally high coupon rate.
4. The selection of all senior securities for investment should be subject to rules of exclusion and to specific quantitative data.
Let us explain each point in lay-man terms :
Point 1 : Selecting a fixed deposit is determined less by legal rules that govern the contract of the fixed deposit and more by the strength and soundness of the bank. By soundness of the bank we largely mean the quality of its loan assets and its viability as a business enterprise. In other words Graham and Dodd eloquently put it as - the investor must aim to avoid trouble rather than aim to protect himself in the event of trouble.
Point 2 : The soundness of the bank must be measured under times of general economic stress(for example now) rather than when times are good.
Point 3 : The “higher risk-higher reward” adage does not work in the investment of fixed deposits. The investor in a fixed deposit has a fixed upside in the form of interest and an unlimited downside of loss of his principal in the case of default. To assume a higher interest will “insure” against higher probability of default is wishful thinking and seldom pans out in reality.
Point 4 : Selection of fixed income securities must start with a minimum standard of safety. Only those which fall within this bucket must be taken up for further investigation.
A fifth point applicable particularly to investors in Indian Rupee denominated fixed income securities is the incidence of tax and inflation. Inflation is a silent way of defaulting by national governments. Bond holders must be aware of the impact tax and inflation have on the “real” value of their fixed income investments. Hyper inflationary periods have left investors in Indian fixed income securities holding worthless pieces of paper at maturity.
Investing in fixed income securities is skewed from the start given its unfair payoff structure of only interest for the upside and possibility of loss of capital on the downside. Nevertheless the retail investor applying the above five principles of fixed income security selection can have reasonably good tax and inflation adjusted outcomes. Debt mutual funds in India have inherently superior tax treatments compared to fixed deposits. Suitable selection of conservatively managed debt mutual funds which adhere to the tenets of Graham and Dodd can result in reasonably good outcomes for the Indian investor.