Too big to fail, so why have deposit insurance?

TB Kapali | Updated on March 11, 2020

The consolidation of banks into larger entities brings into effect the ‘too big to fail’ norm, where such insurance may not apply

An important financial-system related announcement in the recent Budget was about deposit insurance and a reworked Financial Resolution and Deposit Insurance (FRDI) Bill.

Insurance on bank deposits is proposed to be raised to ₹5 lakh for each account-holder from the current ₹1 lakh. A modified Bill for resolution of failing financial firms (banks and non-bank financial firms) also may be reintroduced in the future, the Finance Minister has indicated.

These announcements have generally been welcomed. It has been pointed out, for instance, that given the erosion in the purchasing power of the rupee (in the last 23 years since the previous deposit insurance cap fixation in 1993), the increase in the deposit insurance limit was long overdue. Actually, going by official long-term data, average annual inflation has been 9 per cent in the past 40 years (barring some brief years of lower inflation in the early 2000s and after 2014). Applying that number should, therefore, have seen the deposit insurance cover at nearly ₹10 lakh.

Another point made in the discussions on this subject is that a majority — more than 90 per cent — of bank accounts are likely to be covered by the enhanced limit, but in terms of value, only around a third of the deposits may be covered. Actually, this is another statistic which highlights the skewed distribution of income and savings (in the form of bank deposits) in India.

The proposed modified FRDI Bill also has been welcomed as necessary in the backdrop of recent developments in both the non-bank and bank sectors.

Larger issue of relevance

Be that as it may, this article takes the stand that the relevance of any level of deposit insurance and a financial resolution regime is intimately tied to the nature and structure of the financial industry itself. When the organisational structure of the financial industry — comprising banks and non-banks — is such that almost all firms in the industry are systemically important and are therefore “too big to fail” (TBTF), where is the relevance and need for elaborate schemes of deposit insurance and voluminous legalities for resolving financial firms?

That is, deposit insurance and a clearly laid out legal pathway for resolving financial firms will be required only if firms are allowed to fail. If other elements of public policy are creating banking and non-banking behemoths that are TBTF, elaborate work on deposit insurance and FRDI will most likely remain unused. And, indeed, that seems to be the case with how the structure of the Indian financial industry — be it banks or non-banks — is shaping up.

Industry structure

As is well known, one of the major policy moves with respect to public sector banks in the recent past is a significant shrinking of the number of banks. From nearly 30 banks (prior to the SBI mergers), we may be looking at only 10 to 12 public sector banks in a couple of years from now. If 30 can be reduced to 10, this may be shrunk further to, say, eight or even five.

Each of these 10 or 12 banks (excluding SBI that will be far bigger than even the other merged banks) will have balance sheets of at least ₹15-lakh crore.

More importantly, as the balance sheets expand, their business and customer profile will become too similar and, technically, even too correlated. That is, the industry will become even more undiversified than it is already.

The real risk here is that each of these mega institutions will be systemically important (TBTF). The last straw, so to say, will be their highly correlated relationships. Risks then will flow easily from one systemically important institution to another.

Now, in such an environment, will any regulator or financial resolution authority be able to decisively take a weak or failing firm through the resolution process at all? Or, can any public authority stick to the letter of the law and limit deposit insurance only to ₹5 lakh? It can lead to a run on the other depository and non-depository institutions also.

In effect, no TBTF institution can be allowed to fail.

Deposit insurance is a wonderful concept that tries to balance “bank run risk” with the risk of moral hazard. But, in a TBTF environment, it will not be needed. We need a large number of small, non-correlated firms in the industry to operationalise the idea.

The writer is a Chennai-based financial consultant

Published on March 11, 2020

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