Finance Minister Nirmala Sitharaman has raised the bank deposit insurance to Rs 5 lakh from Rs 1 lakh. Not only was this long overdue — the last time the cap was revised was in 1993 — but it was also a response to the public outcry that followed the introduction of the Financial Resolution and Deposit Insurance [FRDI] Bill in the Modi-I government, when many depositors discovered they were only insured up to Rs 1 lakh for their bank deposits.
If a bank fails today, each account holder is eligible to receive up to Rs 5 lakh against her deposits in the bank.
Since three-fourth of India’s banking system consists of public sector banks, most depositors believe they have a government guarantee for their deposits. Indeed, the misinformation surrounding the Bill suggested that India was somehow moving from an infinite guarantee for bank deposits to a cap of Rs 1 lakh. This raised fear in the public, especially at a time when bad news was coming out about non-performing assets [NPAs] and losses being made by banks.
A “bail-in” clause in the Bill that proposed to convert debt to equity when a bank failed was the last straw and led to its withdrawal.
Finance Minister Sitharaman has now said that the bill is being reconsidered and may be brought back. This could be a very important reform in laying the foundations of a stronger financial system and addressing fundamental problems with the banking system in India.
The Resolution Authority proposed under the bill would have the power to sell off a weak bank, rather than wait for it to fail and then give out deposit insurance, as the Deposit Insurance Corporation has to do currently.
The objectives of deposit insurance are consumer protection and systemic stability. Both these objectives are interdependent. Having deposit insurance helps reduce the risk of bank runs, which helps maintain the safety and soundness of banks necessary for consumer protection. For larger banks, this is also important from the point of view of systemic stability.
However, if too much of the value of deposits is fully covered, the banks will not be subjected to market discipline that comes from uninsured deposits gravitating towards banks that offer good risk-return profiles on deposits.
This also creates the problem of what economists call “moral hazard” — since someone else is insuring the event of bad outcome, banks will do poor risk management. So, deciding the deposit insurance coverage is a question of finding a balance between these concerns.
An automatic check
Ideally, the power to set deposit insurance limit should be given to the Resolution Authority established under the FRDI Bill. Flexibility is important, because in times of systemic crisis, there may be a need to raise the deposit insurance limit to avoid systemwide runs on banks.
During the 2008-09 crisis, 19 countries changed the rules to extend the deposit insurance to fully cover all bank deposits, and 29 other countries raised the deposit insurance coverage either permanently or temporarily.
However, some deposit insurance cap may be given in the law to make sure that it is not reduced below that level. Rs 5 lakh can be the minimum cap. This cap would give the depositors comfort when the law is discussed in the public. Thereafter, the Resolution Authority may raise the cap from time to time.
It is better if deposit insurance is provided along with a resolution framework, which has been missing until now. A resolution regime can help ensure that deposit insurance payouts are not always required, as timely resolution would protect the value of the failing bank. This reduces the probability of having to make deposit insurance payouts. Thus, having a resolution regime should make it possible to raise the deposit insurance limit without substantial costs to the economy.
One of the most important elements of the FRDI Bill that will set up the Resolution Authority will be about the sharing of regulatory information. Consider the example of a weak bank. A large number of banks have been hiding bad assets. Their NPAs were not classified as NPAs for a long time. Such regulatory failure was possible because there are no checks and balances. The RBI is the only authority looking at bank accounts and there is no one looking over its shoulder.
It is important that the authority gets all the regulatory information. This sharing of information itself would serve as an automatic check on the quality of regulatory analysis that goes into classifying financial firms as healthy or weak.
If depositors have to be protected, the Resolution Authority must be given access to information before it is too late. It should be allowed to raise the alarm before a bank is in deep trouble. It has the incentive to sell off a weak bank before it fails because then it does not have to give out deposit insurance. Thus, it saves money.
Finally, we come to the political difficulties related to the FRDI Bill. For starters, the Resolution Authority can cover private sector banks. This will reduce the political opposition to the bill while creating the capacity to sell off failing private banks, for which there is no legal framework today.
The author is an economist and a professor at the National Institute of Public Finance and Policy. Views are personal.