Bank failures are not uncommon in the US. But the manner in which both the failures — the Silicon Valley Bank and the Signature Bank — were handled was rather controversial, particularly the protection of all deposits by the FDIC, against the extant insurance coverage limit of $250,000.

The FDIC’s current action was justified under “systemic risk exception”.

It was thought that under the present economic conditions in the US (besides the geopolitical tensions), if the two bank failures snowballed into bank ‘runs’ over a large part of the banking system like, say, the sub-prime crisis, then inflation management through policy rate hikes would have been thwarted and the socio-economic cost would have been exceedingly high.

However, concerns arose over treating the two banks as ‘too-big-to-fail’ and consequently extending blanket deposit insurance (DI) coverage.

Moral hazard concerns

DI is aimed at protecting the small depositors who are financially naïve and cannot monitor their banks; therefore, their risk perception level is low. In such circumstances, DI helps protect such depositors against possible or actual loss from a bank failure.

However, the protected depositors are not incentivised to monitor their banks’ activities or risk-return profiles. Thus, there is an absence of ‘market discipline’ which instigates banks to assume higher risk profile than the principles of sound banking operations would require them to. Hence, a limitless DI could be an issue of debate. Entities who stand to lose in case a bank fails are the equity holders, subordinated creditors and other general creditors.

Moral hazard problem also arises when a bank is on the brink of insolvency. Therefore, it would likely take additional risks and finance speculative projects promising unsustainable returns. If the risks pay off, it returns to profitability, and if they do not, then the bank would have little to lose. Failures are one way of jettisoning uncompetitive units out of the industry, thereby promoting systemic efficiency. However, a blanket DI induces systemic inefficiency.

The Indian banking sector is resilient against the two US bank failures. But the episode holds out some lessons.

As blanket or high DI coverage leads to moral hazard concerns, this should be avoided unless the problem bank is ‘too-big-to-fail’. Migration to risk-based premium system can mitigate the moral hazard concerns

The RBI should comprehensively review the status of interest risk management by banks, especially when it has embarked on a dear money policy against the backdrop of banks holding large investments in government securities. Investment Fluctuation Reserves with banks can cushion marked-to-market losses, but not fully

The RBI also needs to focus on concentration risk management by banks.

The potential of contagion from the Indian banks’ US branches needs to be closely monitored in terms of their exposure to the two failed banks, to the entire US regional banking sector, and to the start-up industry.

Das is a former senior economist of SBI. Views are personal