Gayatri Mann's blog

Central Transfers to States: Role of the Finance Commission

In November 2017, the 15th Finance Commission (Chair: Mr N. K. Singh) was constituted to give recommendations on the transfer of resources from the centre to states for the five year period between 2020-25.  In recent times, there has been some discussion around the role and mandate of the Commission.  In this context, we explain the role of the Finance Commission.

What is the Finance Commission?

The Finance Commission is a constitutional body formed every five years to give suggestions on centre-state financial relations.  Each Finance Commission is required to make recommendations on: (i) sharing of central taxes with states, (ii) distribution of central grants to states, (iii) measures to improve the finances of states to supplement the resources of panchayats and municipalities, and (iv) any other matter referred to it.

Composition of transfers:  The central taxes devolved to states are untied funds, and states can spend them according to their discretion.  Over the years, tax devolved to states has constituted over 80% of the total central transfers to states (Figure 1).  The centre also provides grants to states and local bodies which must be used for specified purposes.  These grants have ranged between 12% to 19% of the total transfers.

Fig 1Over the years the core mandate of the Commission has remained unchanged, though it has been given the additional responsibility of examining various issues.  For instance, the 12th Finance Commission evaluated the fiscal position of states and offered relief to those that enacted their Fiscal Responsibility and Budget Management laws.  The 13th and the 14th Finance Commissionassessed the impact of GST on the economy.  The 13th Finance Commission also incentivised states to increase forest cover by providing additional grants.

15th Finance Commission:  The 15th Finance Commission constituted in November 2017 will recommend central transfers to states.  It has also been mandated to: (i) review the impact of the 14th Finance Commission recommendations on the fiscal position of the centre; (ii) review the debt level of the centre and states, and recommend a roadmap; (iii) study the impact of GST on the economy; and (iv) recommend performance-based incentives for states based on their efforts to control population, promote ease of doing business, and control expenditure on populist measures, among others.

Why is there a need for a Finance Commission?

The Indian federal system allows for the division of power and responsibilities between the centre and states.  Correspondingly, the taxation powers are also broadly divided between the centre and states (Table 1).  State legislatures may devolve some of their taxation powers to local bodies.

Table 1

The centre collects majority of the tax revenue as it enjoys scale economies in the collection of certain taxes.  States have the responsibility of delivering public goods in their areas due to their proximity to local issues and needs.

Sometimes, this leads to states incurring expenditures higher than the revenue generated by them.  Further, due to vast regional disparities some states are unable to raise adequate resources as compared to others.  To address these imbalances, the Finance Commission recommends the extent of central funds to be shared with states.  Prior to 2000, only revenue income tax and union excise duty on certain goods was shared by the centre with states.  A Constitution amendment in 2000 allowed for all central taxes to be shared with states.

Several other federal countries, such as Pakistan, Malaysia, and Australia have similar bodies which recommend the manner in which central funds will be shared with states.

Tax devolution to states

Table 2The 14th Finance Commission considerably increased the devolution of taxes from the centre to states from 32% to 42%.  The Commission had recommended that tax devolution should be the primary source of transfer of funds to states.  This would increase the flow of unconditional transfers and give states more flexibility in their spending.

The share in central taxes is distributed among states based on a formula.   Previous Finance Commissions have considered various factors to determine the criteria such as the population and income needs of states, their area and infrastructure, etc.  Further, the weightage assigned to each criterion has varied with each Finance Commission.

The criteria used by the 11th to 14thFinance Commissions are given in Table 2, along with the weight assigned to them.  State level details of the criteria used by the 14th Finance Commission are given in Table 3.

  • Population is an indicator of the expenditure needs of a state. Over the years, Finance Commissions have used population data of the 1971 Census.  The 14th Finance Commission used the 2011 population data, in addition to the 1971 data.  The 15th Finance Commission has been mandated to use data from the 2011 Census.
  • Area is used as a criterion as a state with larger area has to incur additional administrative costs to deliver services.
  • Income distance is the difference between the per capita income of a state with the average per capita income of all states. States with lower per capita income may be given a higher share to maintain equity among states.
  • Forest cover indicates that states with large forest covers bear the cost of not having area available for other economic activities. Therefore, the rationale is that these states may be given a higher share.

Table 3

Grants-in-Aid

Besides the taxes devolved to states, another source of transfers from the centre to states is grants-in-aid.  As per the recommendations of the 14th Finance Commission, grants-in-aid constitute 12% of the central transfers to states.  The 14th Finance Commission had recommended grants to states for three purposes: (i) disaster relief, (ii) local bodies, and (iii) revenue deficit.

Resolving failure of financial firms: The FRDI Bill explained

The Financial Resolution and Deposit Insurance Bill, 2017 was introduced in Parliament during Monsoon Session 2017.[1]   The Bill proposes to create a framework for monitoring financial firms such as banks, insurance companies, and stock exchanges; pre-empt risk to their financial position; and resolve them if they fail to honour their obligations (such as repaying depositors).  To ensure continuity of a failing firm, it may be resolved by merging it with another firm, transferring its assets and liabilities, or reducing its debt.  If resolution is found to be unviable, the firm may be liquidated, and its assets sold to repay its creditors.

After introduction, the Bill was referred to a Joint Committee of Parliament for examination, and the Committee’s report is expected in the Winter Session 2017.  The Committee has been inviting stakeholders to give their inputs on the Bill, consulting experts, and undertaking study tours.  In this context, we discuss the provisions of the Bill and some issues for consideration.

What are financial firms?

Financial firms include banks, insurance companies, and stock exchanges, among others.  These firms accept deposits from consumers, channel these deposits into investments, provide loans, and manage payment systems that facilitate transactions in the country.  These firms are an integral part of the financial system, and since they transact with each other, their failure may have an adverse impact on financial stability and result in consumers losing their deposits and investments.

As witnessed in 2008, the failure of a firm (Lehman Brothers) impacted the financial system across the world, and triggered a global financial crisis.  After the crisis, various countries have sought to consolidate their laws to develop specialised capabilities for resolving failure of financial firms and to prevent the occurrence of another crisis. [2]

What is the current framework to resolve financial firms? What does the Bill propose?

Currently, there is no specialised law for the resolution of financial firms in India.  Provisions to resolve failure of financial firms are found scattered across different laws.2  Resolution or winding up of firms is managed by the regulators for various kinds of financial firms (i.e. the Reserve Bank of India (RBI) for banks, the Insurance Regulatory and Development Authority (IRDA) for insurance companies, and the Securities and Exchange Board of India (SEBI) for stock exchanges.)  However, under the current framework, powers of these regulators to resolve similar entities may vary (e.g. RBI has powers to wind-up or merge scheduled commercial banks, but not co-operative banks.)

The Bill seeks to create a consolidated framework for the resolution of financial firms by creating a Resolution Corporation. The Resolution Corporation will include representatives from all financial sector regulators and the ministry of finance, among others.  The Corporation will monitor these firms to pre-empt failure, and resolve or liquidate them in case of such failure.

How does the Resolution Corporation monitor and prevent failure of financial firms?

Risk based classification: The Resolution Corporation or the regulators (such as the RBI for banks, IRDA for insurance companies or SEBI for the stock exchanges) will classify financial firms under five categories, based on their risk of failure (see Figure 1).  This classification will be based on adequacy of capital, assets and liabilities, and capability of management, among other criteria.  The Bill proposes to allow both, the regulator and the Corporation, to monitor and classify firms based on their risk to failure.

Corrective Action:  Based on the risk to failure, the Resolution Corporation or regulators may direct the firms to take certain corrective action.  For example, if the firm is at a higher risk to failure (under ‘material’ or ‘imminent’ categories), the Resolution Corporation or the regulator may: (i) prevent it from accepting deposits from consumers, (ii) prohibit the firm from acquiring other businesses, or (iii) require it to increase its capital.  Further, these firms will formulate resolution and restoration plans to prepare a strategy for improving their financial position and resolving the firm in case it fails.

While the Bill specifies that the financial firms will be classified based on risk, it does not provide a mechanism for these firms to appeal this decision.   One argument to not allow an appeal may be that certain decisions of the Corporation may require urgent action to prevent the financial firm from failing. However, this may leave aggrieved persons without a recourse to challenge the decision of the Corporation if they are unsatisfied.

Figure 1: Monitoring and resolution of financial firmsFig 1 edited

Sources: The Financial Resolution and Deposit Insurance Bill, 2017; PRS.

 

How will the Resolution Corporation resolve financial firms that have failed?

The Resolution Corporation will take over the administration of a financial firm from the date of its classification as  ‘critical’ (i.e. if it is on the verge of failure.)  The Resolution Corporation will resolve the firm using any of the methods specified in the Bill, within one year.  This time limit may be extended by another year (i.e. maximum limit of two years).   During this period, the firm will be immune against all legal actions.

The Resolution Corporation can resolve a financial firm using any of the following methods: (i) transferring the assets and liabilities of the firm to another firm, (ii) merger or acquisition of the firm, (iii) creating a bridge financial firm (where a new company is created to take over the assets, liabilities and management of the failing firm), (iv) bail-in (internally transferring or converting the debt of the firm), or (v) liquidate the firm to repay its creditors.

If the Resolution Corporation fails to resolve the firm within a maximum period of two years, the firm will automatically go in for liquidation.  The Bill specifies the order of priority in which creditors will be repaid in case of liquidation, with the amount paid to depositors as deposit insurance getting preference over other creditors.

While the Bill specifies that resolution will commence upon classification as ‘critical’, the point at which this process will end may not be evident in certain cases.  For example, in case of transfer, merger or liquidation, the end of the process may be inferred from when the operations are transferred or liquidation is completed, but for some other methods such as bail-in, the point at which the resolution process will be completed may be unclear.

Does the Bill guarantee the repayment of bank deposits?

The Resolution Corporation will provide deposit insurance to banks up to a certain limit.  This implies, that the Corporation will guarantee the repayment of a certain amount to each depositor in case the bank fails.  Currently, the Deposit Insurance and Credit Guarantee Corporation (DICGC) provides deposit insurance for bank deposits up to 1 lakh rupees per depositor.[3]  The Bill proposes to subsume the functions of the DICGC under the Resolution Corporation.

[1].  The Financial Resolution and Deposit Insurance Bill, 2017, http://www.prsindia.org/uploads/media/Financial%20Resolution%20Bill,%202017/Financial%20Resolution%20Bill,%202017.pdf

[2]. Report of the Committee to Draft Code on Resolution of Financial Firms, September 2016, http://www.prsindia.org/uploads/media/Financial%20Resolution%20Bill,%202017/FRDI%20Bill%20Drafting%20Committee%20Report.pdf

[3]. The Deposit Insurance and Credit Guarantee Corporation Act, 1961, http://www.prsindia.org/uploads/media/Financial%20Resolution%20Bill,%202017/DICGC%20Act,%