"Modifications to the bank resolution framework, if implemented as recommended, may increase the risks for many creditors of domestic lenders, including holders of both senior and subordinated debt," Gene Fang and Srikanth Vadlamani, analysts at Moody's Investors Service said in a note.
At the same time, the analysts noted that while it is too early to form any definitive conclusions, in the event of its implementation, Moody's could lower its assumption of government support for all categories of bank securities, including senior unsecured debt.
In June 2012, the sub-committee of the Financial Stability and Development Council (FSDC) had constituted a high-level working group with then RBI Deputy Governor Anand Sinha as chairperson and the then Economic Affairs Secretary Arvind Mayaram as co-chairperson, to suggest ways to strengthen bank resolution regime.
The report was presented to the RBI Governor on May 2 and the central bank has sought public comments on the report until May 31.
Implementation of the report will also require establishing new regulatory bodies and legal framework, a complex and lengthy process.
The problem could arise for creditors as senior debt holders of a bank get priority over other bond holders if the bank goes in for liquidation. Subordinated debt, also known as junior debt, is riskier and considered as second-level debt at the time of winding up operation.
In addition, Moody's said there could be a significant differentiation between bank senior unsecured debt and deposit ratings resulting from the principle of depositor preference, as currently defined under the proposal.
The high-level committee report specifically stated depositor preference as a policy objective, which excludes deposits, inter-bank liabilities and short-term debt from losses in order to limit systemic instabilities.
"If legal and administrative structures recommended in the report are established, it will increase risks for bank creditors," the Moody's note said, adding "the financial resolution authority (FRA) would be able to impose losses on all creditors to the extent necessary for protection of depositor claims."
The other recommendations were setting up an independent regulatory institution called FRA, with the ability to "bail in" all stakeholders in a resolution process except for stakeholders in deposits, inter-bank liabilities and short-term funds.
The report has also called for creating a framework for "prompt corrective action" that may apply increasing levels of regulatory oversight and prevent institutions becoming progressively weaker.
Moody's said that while depositor preference is usually only applied to natural persons and not legal persons, the scope of the proposed modifications extends depositor preference significantly beyond what is usual, for example, to the coverage of interbank deposits.
Such a policy could be credit negative for other senior unsecured creditors should it place a very large percentage of liabilities ahead of them in the queue in the event of insolvency.
At the same time, Moody's said the proposed changes would not necessarily eliminate probability of support completely for those other senior unsecured creditors.
Normally, resolution authorities reserve the right to choose resolution tools aside from bail in to avoid the systemic risks of contagion.
After the 2008 global credit crisis, the government, along with other G-20 members of the Basel-based Financial Stability Board (FSB), had agreed to comply by the end of 2015 with the "key attributes of effective resolution regimes" that the FSB published in October 2011.
In June 2012, the government set up a working group to explore potential gaps between the FSB key attributes and the country's existing bank resolution framework and the report was submitted on May 2 this year.