Financial safety net is sine qua non for addressing macro-financial risks. Deposit insurance, a major aspect of financial safety, plays a crucial role in both ‘crisis prevention’ and ‘crisis management’.
It is important that during a financial crisis, in general, and banking crisis, in particular, the “unsophisticated” depositors are assured that their money is safe, albeit to a certain extent.
The US Federal Deposit Insurance Corporation (FDIC) is the oldest deposit insurer amongst all, having been established in the post-Great Depression time in 1933. India was the second country, after the US, to provide insurance cover to bank deposits.
The Deposit Insurance Corporation Act, which was passed by Parliament after long debates and discussions, received Presidential assent towards the end of 1961. The Act came into force from January 1, 1962, when the Deposit Insurance Corporation (DIC) was established under the aegis of the RBI.
However, it is surprising that many are unaware of the facility of deposit insurance. One reason for this could be that in India banks are perceived to be either too-big-to-fail or impossible-to-fail on account of Government or RBI backing. While this may be true for the public sector banks, it certainly is not true in the case of private banks, foreign banks operating in India and the large number of cooperative banks.
Coverage
Initially, the insurance cover was limited to Rs 1,500 per depositor for deposits held by him in all the branches of a bank. This insurance limit was enhanced from time to time.
Currently, the insurance limit stands at Rs 1,00,000, which came into effect from May 1, 1993. The substantial increase in deposit coverage from Rs 30,000 to Rs 1 lakh in May 1993 was the outcome of the review of the scheme in the background of the security scam in 1992 and the subsequent liquidation of Bank of Karad.
This limit, however, needs to be increased. The IMF uses twice per capita income as a rule of thumb to determine a ‘small’ depositor. This would work out to almost Rs 1,50,000 for our country (computed on the basis of figures published in RBI’s Handbook of Statistics for Indian Economy, 2011-12 ). Therefore, there is a case for increasing the per depositor insurance limit by at least 50 per cent.
The second motivation comes from the RBI’s ‘Report of the Committee on Customer Service in Banks’ (headed by M. Damodaran) in 2011. The committee recommended a big increase in the cover to at least Rs 5,00,000 so as to encourage individuals to keep all their deposits in a bank convenient for them. The Committee felt that a way should be found to insure 100 per cent of the deposits by making necessary amendments to the relevant pieces of legislation.
The need to increase deposit insurance limit also stems from the deregulation of savings bank interest rates. As some banks offer higher rates for SB deposits of over Rs 1 lakh, more deposits are expected to accrue in that slab. The deposit insurance limit, however, is only up to Rs 1 lakh.
Premium
The Indian Deposit Insurance System follows a flat-rate premium structure, that is, the premium does not vary with the risk profile of the insured banks. Currently, it is 10 paise for Rs 100 of deposits. It is widely acknowledged that a flat-rate premium structure per se generates perverse incentives that prompt bank managers to take additional, unwarranted risks.
Equally unequivocal is the argument as to how the more conservatively run institutions are penalised under a flat-rate premium structure.
Premiums have to be risk-related so that the moral hazard problem is precluded. Higher the risk-based capital of a bank, lower the premiums it should pay. This will reinforce the incentive to build and maintain strong capital.
Deposit Insurance Fund
Currently, there is one DIF. The adequacy of the fund is dismally low by any standard of measurement. Furthermore, commercial banks subsidise co-operative banks which are highly fragile. Although cross-subsidisation is embedded in the very business of insurance, its incidence must be minimised.
Two deposit insurance funds may be instituted, one for the commercial banks and the other for cooperative banks. Maintaining a DIF of at least 2-3 per cent of the insured deposits is thought to be reasonably adequate.
In the case of DIF exceeding the target level, insurance premium will have to be adjusted downwards.
The reforms are long-pending. It is time the RBI and the Government acted on these.
(The author is a former commercial bank economist.)