How safe is your bank balance?

The sharp deterioration of public sector banks’ finances in the last couple of years has shaken investors’ confidence. Over ₹1.3 lakh crore has been wiped out of these banks’ market capitalisation over the last five years. Depositors, fortunately, have been unaffected by the recent goings-on. Various regulatory checks in the form of stringent capital adequacy and liquidity norms have acted as an early warning signal. When the United Bank of India crisis (the bank’s tier 1 capital fell below the statutory requirement) unfolded two years back, the Reserve Bank of India stepped in and curbed further lending to protect depositors’ interests.

Also, in India, instances of commercial banks going bust are rare. A whiff of trouble and the RBI usually steps in; what follows is a merger or consolidation of the weak bank into a larger bank. The biggest backing that state-owned banks have at all times is that of the Centre, pumping in money to meet their requirements.

Sadly, though, such tacit support from the Centre and the regulator has stood in the way of the industry creating a robust deposit insurance system in India. In contrast, globally, since the financial crisis that began in 2007, there has been an increased focus on the need to review insurance coverage levels. According to a March 2013 paper put out by the International Association of Deposit Insurers (IADI), many countries increased coverage limits sharply to fully protect virtually all depositors. In India, the insurance cover is long due for a revision.

It is hardly a revelation that in India less than a third of bank deposits in value terms are insured by the Deposit Insurance and Credit Guarantee Corporation of India (DICGC), a wholly owned subsidiary of the RBI. The deposit insurance covers all commercial banks, local area banks, regional rural banks and cooperative banks. If a bank goes belly up, the DICGC pays back the insured amount to the depositor. But the catch here is the low insurance limit which is restricted to just ₹1 lakh per depositor per bank. The coverage under DICGC was last raised in 1993, from ₹30,000 to ₹1 lakh. Over such a long period of time, the real value of insurance is bound to have diminished if inflation, rising income levels, and the size of deposits are taken into account.

Adjusted for inflation alone, over the last two decades, the real value of the ₹1-lakh limit works out to about ₹5 lakh. India can draw lessons from other countries such as Mexico where coverage levels are indexed to inflation to maintain the real value of the deposit insurance.

In Mexico, bank deposits are insured in terms of inflation indexed currency units (UDI) which are published daily on the Bank of Mexico’s website. Deposit cover amounts to 400,000 UDIs. One UDI is currently worth about 5.5 pesos; ten years ago it was worth 3.7 pesos. The total amount of money insured currently works out to about 2.2 million pesos or about $1,16,000.

In India, the deposit insurance currently is a meagre $1500. Canada, Brazil, Indonesia, Switzerland, France and the US all insure an amount upwards of $70,000 per depositor. In the US, the Federal Deposit Insurance Corporation offers an insurance coverage of $250,000, a limit that was revised in 2009 from the earlier $100,000. Along with a higher deposit insurance cover, countries such as the US, Japan, Indonesia, France and Australia cover 60-70 per cent of total deposits.

Many would question whether such a comparison with other countries is appropriate, given their varied size of deposits. But even if we compare the cover limit taking into consideration the distribution of deposits according to size, India’s deposit cover falls badly short. In the US, nearly half the deposits (by value) are below the threshold limit (insurance cover) of $250,000. In contrast, in India, deposits that are less than ₹1 lakh in size are just 15 per cent of total deposits (by value). A chunk — 55 per cent of deposits — is in the ₹1-lakh to ₹15-lakh bucket.

Interestingly, a decade ago, nearly 60 per cent of the deposits in India were covered under the DICGC. This was also the time when nearly 45 per cent of bank deposits where in the less than ₹1-lakh bucket. The deposit cover in India has clearly not kept pace with the rising income levels and the resultant sharp jump in the average size of deposits over the past decade.

Still, many would argue that the additional safety nets in India in the form of higher reserve requirement — SLR and CRR — make up for the shortfall. It is true that Indian banks hold anywhere between 25-28 per cent of their deposits in safe and liquid assets. But a back of the envelope calculation suggests that this may add just about ₹15,000-₹18,000 per account as buffer at the system level.

The Centre’s backing of PSBs is, of course, unique to India. But it is taxpayers, after all, who are ultimately bearing the risk of catastrophe — the insured (depositor) in effect becomes the re-insurer!

Globally, the jury is still out on what constitutes the right coverage limit. If most depositors were to be fully covered, it would create a moral hazard. In the past, deposit insurance sought to balance the objectives of financial stability while also nudging depositors to regularly monitor their banks’ risk profile to create a sort of market discipline on banks.

However, IADI found that over the last 20 years — especially during financial crises — most depositors, if not adequately protected, will indiscriminately run from both sound and weak banks. Low coverage limits can undermine financial stability. Also, most depositors, particularly in India, are not sufficiently well-informed to exercise caution when it comes to assessing banks’ risk profile.

While the current premium in India is a low 10 paise for ₹100 of deposit, raising it to increase the insurance cover raised some concerns in the past. This is because, so far in India, beneficiaries of the deposit insurance system have mainly been the urban cooperative banks. The last claim settled in respect of a commercial bank was way back in 2002. But introducing a risk-based premium for banks in place of a flat structure can mitigate concerns of cross-subsidisation.

The RBI would do well to implement the differential premium system which was proposed by the panel headed by Jasbir Singh last year. This includes classifying banks into four risk categories, and having a rising premium rate structure as a bank’s rating deteriorates.