Bank deposit insurance: Many risks, not enough return

S Kalyanasundaram | Updated on June 07, 2020

Instead of providing enhanced deposit insurance coverage, the regulator must tone up supervisory role and ensure bank failures do not happen at all

A little while ago, it was reported that as per a study conducted by State Bank of India’s economic research department, there was a dire need to revisit the insurance coverage of the bank deposits, as over the years, the percentage of assessable deposits has declined from a high of 75 per cent in FY12 to 28 per cent in FY18. The upper limit of ₹1 lakh per depositor has outlived its shelf life, and there was a need to revisit it, said the report.

Accordinaly, the Deposit Insurance and Credit Guarantee Corporation will now provide coverage for bank deposits up to ₹5 lakh. Earlier, as the DICGC provided coverage for credit default as well (for small loans etc), it woyld use the premium collected from banks for deposit coverage to settle credit guarantee claims. But now, it provides coverage only for bank deposits.

As the claims are mostly from cooperative banks, and sometimes from private banks, so far, the DICGC settled them with premium collection from public sector banks. Never in the history of the DICGC any has PSB made a claim, although there was failure of New Bank of India (a nationalised bank), which was merged with Punjab National Bank.

The present system of coverage by the DICGC itself contains some flaws:

As the government predominantly owns PSBs, there is no need for any other organisation to provide guarantee for the deposits of these banks. However, they have been mandated to pay the premium to the DICGC for coverage.

Insurance is a risk coverage mechanism, and premium should be paid by the person who wants risk coverage. However, deposit insurance premium is presently paid by the banks out of their earnings, not by the depositors.

The DICGC predominantly uses premium collected from PSBs to settle the claim of cooperative banks, which is unfair.

With enhanced coverage, there will be a 5x increase in instances of PSBs bailing out private banks.

While recommending enhanced coverage, it was also suggested that general insurance companies could provide coverage. No final decision seems to have been taken on this count.

Deposit insurance not always viable

Basically, insurance can be viable only when there is a large number of similar exposure units. Say, for auto insurance, there should be a large number of cars who see coverage from an insurance company. One company cannot provide insurance for just 100-200 cars. There should be a large group of cars, so that claims are settled from premium collected from these units.

There is a principle called ‘sharing of losses’ under insurance. This means spreading of losses incurred by a few over the entire group, so that average loss is substituted for actual loss. Grouping of a large number of units with similar risks helps reduce the loss through the ‘law of large number’. The advantage of this law is that losses can be shared and future losses an be predicted.

For 2018-19, the number of scheduled banks and scheduled commercial banks was reporting to the RBI was 222. There were 32 State cooperative banks and 55 urban cooperative banks operating in the country.

Though there are a large number of bank accounts covered under insurance, the number of units covered should be taken only as number of banks covered. Only a few hundred banks can be covered. This is not a large number worth any insurance company’s time.

As there are always inter-bank unreconciled transactions, the failure of any one will have a contagion effect and will adversely affect many other banks. Insurance companies may not be willing to underwrite such a proposal.

Insurance is also collective bearing of risk. All the insured must contribute the premium towards a fund, and only upon failure of any bank must claims be settled. When the interest rate is so low, and does not even cover inflation, expecting the depositors to bear insurance premium may not work out. Payment of premium by banks for enhanced coverage will also adversely affect their bottomline.

Financial assets are different

Risk coverage for financial assets cannot be on the same lines as tangible assets. In fact, when someone invests in a financial asset, he takes on a credit risk, and return expected is based on the perception of this risk. If bank deposits are to be insured, then why not company deposits, debentures and even equities? There is a concept of ‘risk and return’, and when there is similar risk, there will only be similar return.

Banking regulation across the world is made to ensure stability of banks. We have provisions like cash reserve ratio, statutory liquidity ratio, capital adequacy ratio, prudential norms; group exposure limits etc to ensure that banks operate within safe limits. In spite of these prescriptions, if any bank fails, this means that there is lack of supervisory mechanism and timely intervention by the regulator.

Instead of providing enhanced coverage of deposit insurance, the regulator must tone up supervisory role and ensure that bank failures do not happen at all.

The writer is a retired banker

Published on June 07, 2020

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