Reforming Deposit Insurance

This is the last of three articles from my younger days that I am posting here on this site. All because they continue to be relevant, and are not available in the public domain. This article on deposit insurance goes back to July 2000. It is a critique of some of the key recommendations of the Working Group on Reform of Deposit Insurance in India (Chairman: Jagdish Capoor). You can find the report chapters here.

The Working Group had a unique structure. According to the Report on the RBI website, there was an Advisory Group chaired by Late Jagdish Capoor, then Deputy Governor, and had as its members/invitees, two other Deputy Governors, one former Deputy Governor, two former Chairmen of bank/FI (Bank of India and IDBI), a Professor from IGIDR (in fact, he was then Asst. Prof.), Director of NIBM, and ED of DICGC. There was also a Working Group proper consisting of officials from various organizations, including Reserve Bank of India, and a group of officers from different departments of the Reserve Bank who contributed to the report.

The article cautions against introducing risk based premia and also argues against the proposal to withdraw deposit insurance for weak banks. This was published in Economic Times dated 12 July 2000. In view of the continuing and global relevance of some of the observations, and since the article is not available on the website of Economic Times, it is being reproduced here.

Postscript: I would like to express my thanks and gratitude to three persons. First, Late S.S. Tarapore, for kindly going through my draft. When I wrote the article, I was occupying a cabin close to his, and had occasion to interact with him often. Some of his pet ideas, such as withdrawing deposit insurance for weak banks, were there in the report, and was one of the targets of my critique. So, he just returned the draft with a grim face and nothing but a nod. I took this as a sign of approval. I was to work closely with him from a few months later (more on this in a future post).

The second is A. Chandramouleeswaran, who was Executive Director of the Deposit Insurance and Credit Guarantee Corporation, and was a member of the Advisory Group. He told me some years later when I met him in Chennai, that he had given permission to publish the article.

The third is Smt. Shyamala Gopinath. She was then Chief General Manager in charge of the Bank’s Department of External Investments and Operations and was to later become Executive Director and Deputy Governor. I had never worked with her directly. But, on the day the article was published, she called me up at home (I was on leave) and congratulated me for the article.

One of the best things that I liked about working with the Reserve Bank of India was the intellectual freedom that one enjoyed. One could express divergent views, both orally and in writing, and not be victimised for it. At least, that was my experience. Maybe that was just my experience. I was fortunate to have worked with many central banking stalwarts; but, of course, there will always be a few exceptions. But, they are stories for future posts.

Within about two to three weeks of my article being published, I appeared for interview for selection to Grade D, where I would be designated Deputy General Manager, the lowest level among senior officers. I was selected.

Please read the article below, as original published in Economic Times dated 12 July 2000.

Deposit Insurance: A Way to Cover

Reforms in deposit insurance should ensure more market discipline among other things.

Reforming deposit insurance so as to provide the right incentives, for sound banking to the owners, management and depositors alike has been receiving the attention of bank regulators world over for the last decade and a half. The Basle (later changed to Basel) Committee on Banking Supervision had, in 1997, emphasised the role of risk-based insurance premia in providing appropriate market discipline. The recent monetary policy statement also draws attention to the impending changes in India.

The report on reforming deposit insurance in India was made public recently for generating greater public debate and discussion on the subject. For probably the first time since 1961, when deposit insurance was introduced in India, a wide range of issues relating to deposit insurance has been comprehensively dealt with in the report. Its far-reaching recommendations include introduction of risk-based insurance premia and co-insurance, where deposits beyond a level are only partly insured. It also envisages separate insurance funds for commercial and cooperative banks and a greater clarity in the role and responsibilities of a reconstituted Deposit Insurance Corporation including assigning it the role of liquidator and receiver.

Deposit insurance n India has to be viewed against the fact that public sector banks control over 80 per cent of bank assets. A blanket protection to depositors is implied under such a system. Worse still, such protection would be expected, or even demanded, in respect of the remaining 20 per cent of the system. This would make some of the recommendations relating to insurance and withdrawal of deposit insurance lack credibility in practice. Such credibility can be gained only with increasing privatisation. While comparing with international best practices, this crucial difference needs to be borne in mind.

The number of countries opting for risk-based insurance premiums has increased considerably during the last few years. The rationale is that the premium should reflect the risk posed by the insured institution. Moreover, it removes the moral hazard inherent in flat premia. But, in the present Indian context, one may rightly ask, risk posed to whom? To the insuring agency, to the government or to the taxpayer? In a system which is predominantly government-owned and where orderly takeovers are arranged for the other failing banks, risk is practically absent for the deposit insurance agency and the depositors.

Some writers consider instances where assistance in any form has been provided to banks by the government, whether it is the owner or not, as cases of “deemed failures”. Risk-based premia can be justified if, on the above analogy, the deposit insurance agency, which has been collecting premium all along, is also required to share the cost of resolving such “deemed failures”. For this, threshold performance levels need to be defined for all banks. Performance below such levels should trigger a payout from the deposit insurance agency.

Given that the circumstances justifying the introduction of risk-based premium is available, it should be ensured that the premium is graded properly and introduced slowly.

The report recommends premia starting from 5 ps. per Rs. 100 (the current rate) and going up to 24 ps. per Rs 100. In the case of the present weak banks, the additional outflow on account of the increased premium would be around Rs. 30-40 crore per bank. This is rather steep and these banks can hardly afford it at this stage. In USA, which was one among the first to introduce risk-based premia, initially the range was only 8 bps (23-31 cents per US$ 100) which was gradually increased mainly by lowering the lower slab over a period of time to zero. At present, the best banks do not have to pay any premium.

A related issue is the recommendation that deposit insurance be withdrawn in the case of banks exhibiting certain adverse features for long. From a depositor’s point of view, this is akin to withdrawal of life insurance soon after a patient displays symptoms of a terminal disease. The depositor would require no better reason than this to “run”. Deposit insurance, which is required to prevent runs, in this case encourages such runs making the failure of the bank somewhat inevitable. If deposit insurance were to be withdrawn for the banks already identified as weak, the result would be catastrophic even if such withdrawal were to take effect only after three years as recommended. Deposit insurance is ultimately a palliative to the depositor to provide comfort in times of trouble and not a favour extended to a bank for good behaviour.

The last issue relates to insuring deposits of non-banking finance companies. The report states that “it is premature to extend deposit insurance cover to the NBFCs immediately. But denying them deposit insurance cover indefinitely may not be prudent, once these entities are adequately regulated and supervised and there is some degree of regulatory parity vis-à-vis banks”. It, therefore, recommends that “extending deposit insurance could be considered after the regulatory and supervisory system is stabilised. Hence, a review can be made after 2 years and deposit insurance be thought of not only for those NBFCs which meet the registration and supervisory norms”.

The above recommendation, in effect, results in a period of ambiguity. International experience shows that ambiguity is as inefficient as implicit insurance. In the event of a large or widespread failure of NBFCs, it would not be practicable to muster support from other peer level institutions in the form of post facto collection of premia or otherwise. Leave alone ambiguity, the fact is that there is no case for extending insurance to NBFCs whatever may be the state of their regulation and supervision.

To answer whether NBFC deposits should be insured, one should retrace the rationale for insuring bank deposits. Banks accept deposits, which are withdrawable on demand, and are key players in the payment system and in the money market. The former means that banks are likely to be victims of rumours and runs. This is the key factor in the seminal paper of Diamond and Dybvig (Journal of Political Economy, 1983) which provides the theoretical case for deposit insurance. Similarly, participation in the payments system and the call money market may raise fears of “domino effects” on other banks and a likelihood of runs on them too.

Deposit insurance, with its braking effect on bank runs, helps reduce the incidence of bank failures and also the systemic effect on other banks.

The above peculiar features of banks are not obtained in NBFCs which do not accept deposits withdrawable on demand. In fact, the minimum period for acceptance of deposits is one year. They are also not part of the payments system or the call money market. As for protecting small depositors, it suffices to ensure that safe avenues for deposit of their savings are available. This need not be stretched to the extent of insuring deposits in all types of institutions where a small depositor chooses to keep her savings. This may amount to insuring avarice. The ambiguity with regard to insuring NBFC deposits needs to be replaced with a total rejection of the proposal.

It is hoped that with the proposed new legislation, the DICGC, minus its credit guarantee baggage, will emerge as a more autonomous body with a greater say in post-inspection strategies and be able to foster deposit insurance as a catalyst in promoting greater market discipline over banks.

G. Sreekumar

The author is an AGM with the Reserve Bank of India. The views are personal. (Published in Economic Times dated 12 July 2000).

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