On August 14, 2024, the Deposit Insurance and Credit Guarantee Corporation (DICGC) hosted the International Conference of the International Association of Deposit Insurers-Asia Pacific Regional Committee.

While addressing the conference, three Deputy Governors of the RBI — MD Patra (also the DICGC Chairman), M Rajeshwar Rao and Swaminathan J — emphasised the need for introducing risk-based premium system (RBPS) — also known as differential or variable premium system — for deposit insurance (DI) in India.

Under RBPS, premiums on deposits are assessed based on the ‘riskiness’ of individual banks. This is contrary to the flat-rate premium system which assesses premiums at a uniform rate across all banks, irrespective of their ‘riskiness’. Thus, risky and non-risky banks pay premium at the same rate, which doesn’t sync with the basic tenets of insurance, although DI is a ‘special’ kind of insurance.

Despite the Deposit Insurance Act, 1961 [Section 15(i)] providing for “different rates … for different categories of insured banks”, the statutorily-established Indian deposit insurance agency in 1962, namely, the Deposit Insurance Corporation, has been following a flat-rate premium system hitherto.

Looking back

The Narasimham Committee on Banking Sector Reforms (1998) underscored the “need to shift from the ‘flat’ rate premiums to ‘risk based’ or ‘variable rate’ premiums”, and recommended that CAMELS (Capital Adequacy, Asset Quality, Management, Earnings, Liquidity and Systems) ratings awarded by the RBI “could form the basis for charging deposit insurance premium.”

Subsequently, three reports recommended different methodologies for RBPS. These included: (a) Report on Reforms in Deposit Insurance in India (RBI) — Chairman: Jagdish Capoor, 1999; this author was a member of the RBI Working Group constituted for the purpose); (b) Report of the Committee on Credit Risk Model (DICGC, 2006); and (c) Report of the Committee on Differential Premium System for Banks in India (DICGC, Chairman: Jasbir Singh, 2015).

However, the recommendations by these committees have not yet been implemented, the prime reasons being (a) model complexities, and (b) data availability, confidentiality and transparency.

Since operationalising a ‘practical’ framework for RBPS has been re-ignited by the aforementioned three Deputy Governors, a simple methodology, at least to begin with, is suggested below which addresses the above issues.

Suggested framework

A bank will be able pay back its deposits in full, with accrued interest, on maturity or on demand, as long as it is solvent. Therefore, the question boils down to what is most likely to make a bank insolvent, in India?

The answer is: significant loan losses or bad asset quality (AQ), which is measured by gross non-performing loans (GNPLs). Higher GNPLs lower net earnings (i.e., total earnings less total expenditure) but raise provisions and contingencies, and resultantly, net profit drops.

Net profit provides the basis for transfer to ‘reserves & surplus’, an important constituent of net worth, besides capital. This underscores the ‘centrality’ of AQ in determining a bank’s solvency.

AQ influences liquidity too, but indirectly and with lags. As poor AQ erodes a bank’s net worth and it resorts to assets sale, a Liquidity problem begins. If the problem is not arrested expeditiously and adequately, creditors/depositors would gradually come to know about the bank’s vulnerability and queue up before the bank for their dues.

In order to eschew a significant depositor run, the bank would resort to ‘fire-sale’ of its assets with losses charged to its net worth. At this stage, the bank would face a full-fledged liquidity problem with adverse implications for its solvency.

In short, in the Indian setting, AQ, as measured by GNPLs, which determines a bank’s vulnerability, can be used to assess the premium rates — banks with higher GNPL ratios paying more premiums and vice versa.

The advantages

GNPL ratios are made public by banks after their statutorily audited annual accounts are announced. Also, their quarterly results give the ratios, albeit unaudited. DICGC can source the ratios internally from the concerned department of the RBI.

Bankers easily comprehend the GNPL concept.

Difficulties encountered in operationalising complicated methodologies that necessitate huge granular data from several sources including banks will be ameliorated.

Even if the GNPL ratios are publicly available, the exact DI premium rates levied on banks can be kept confidential.

The goal of RBPS is to use insurance premium as an additional instrument to leash overly risky behaviour of banks. In India, credit risk dominates the risk profile of banks, and under the flat-rate system, the DI premium has, practically, no influence on credit deployment by them. By contrast, RBPS will augment credit risk management of the insured banks which, in turn, will contribute to systemic efficiency.

Under RBPS, premium rates will be equitably distributed among banks. Today, there’s no justice in charging the same rate to, say, domestic-systematically important banks and co-operative banks.

Pre-requisites for RBPS

In many advanced economies, besides DI premium, depositors constitute a major disciplining force on banks, in addition to shareholders. Contrastingly, in India, shareholder discipline, though visible, is thin, and depositor discipline is yet to crystallise. Therefore, depositor discipline is crucial for RBPS.

Before implementing RBPS, the Deposit Insurance Fund should be bifurcated: one for commercial banks and the other for co-operative banks because both are genetically different, and a combined Fund would hinder determination of appropriate and coherent premium structure.

A major apprehension against RBPS is likely deposit flight from bank/s paying higher premiums to those paying lower premiums. If this were the case, then 55 per cent of deposit insurers worldwide wouldn’t have adopted RBPS today.

Further, in India, retail depositors are dominant, and their choice of banks/branches depends on factors other than banks’ vulnerability. Otherwise, deposits of urban co-operative banks wouldn’t be flourishing; the banks, which were under the Prompt Corrective Action in the past, wouldn’t have recorded deposit growth; and banks with (publicly reported) higher GNPLs wouldn’t be garnering deposits.

Although it is heartening that the idea of RBPS for DI in India is still alive, yet there are many other DI-related issues that need to be fixed for which RBI/DICGC may consider constituting a committee.

The writer, a former senior economist of SBI, has worked on deputation with DICGC and authored two books on deposit insurance. Views are personal

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