How will deposit insurance help if a bank fails?

The story so far: The Union Cabinet last week cleared the Deposit Insurance and Credit Guarantee Corporation (Amendment) Bill, 2021. Under the new amendments, bank deposits of up to ₹5 lakh will be covered by the government in case a bank fails. Earlier, deposits of only up to ₹1 lakh were insured. The Bill also mandates that the Deposit Insurance and Credit Guarantee Corporation (DICGC) must return money owed to depositors within 90 days from when a bank fails. In the past, it has usually taken several years for affected depositors to get their money back.

What is deposit insurance?

Deposit insurance offers protection to the deposits of bank customers in case a bank becomes insolvent. A bank becomes insolvent when its total liabilities exceed its total assets, usually as a result of poor investing or lending decisions. So an insolvent bank may not be able to make good on all of the money that it owes its depositors. In such cases, the government steps in to compensate depositors, usually up to a certain threshold amount. In India, the DICGC is the government agency in charge of protecting the interests of depositors when a bank fails. The DICGC regularly collects money from banks to fund a corpus that is used to compensate depositors if a bank fails. Banks have till now been paying 10 paise to the DICGC for every 100 rupees of deposits that they hold to avail deposit insurance for their customers. Now, after the fresh amendments, banks may be charged up to 15 paise for every 100 rupees. According to the Centre, the raising of the insured deposit amount now to ₹5 lakh means that 98.3% of all bank accounts and 50.9% of all deposit value will be protected by the government. Most countries across the world today offer deposit insurance to bank depositors.

What are the benefits and risks of deposit insurance?

Economists are divided on the merits of deposit insurance. Supporters of deposit insurance argue that it can help boost the confidence depositors have in the banking system. The increased confidence, in turn, can help reduce the risk of a bank run which happens when a large number of worried depositors demand their money from a bank at the same time. In fact, the supporters of deposit insurance argue that deposit insurance arose in the last century or so particularly to tackle the problem of bank runs. The case supporting deposit insurance was mostly popularly made by economists D.W. Diamond and P.H. Dybvig in 1983. The critics of deposit insurance, on the other hand, argue that it leads to moral hazard. When depositors know that their deposits will be protected by the government, they have very little reason to conduct due diligence on the banks in which they deposit their money. In fact, studies show that bank failures have increased since countries began adopting deposit insurance. For example, Demirguc-Kunt and Edward Kane in a 2002 study showed that banks in countries with the highest deposit insurance coverage were five times more fragile than countries offering the lowest coverage.

Some critics also argue that government-backed deposit insurance is very different from private sector insurance. In particular, they point to how government agencies such as the DICGC charge uniform premiums to insure deposits held in different banks with varying risk profiles. This is uncharacteristic of how insurance typically works. Private sector insurers try to segregate customers according to their risk profile and charge appropriate premiums. They also try to rein in moral hazard more effectively. Government-backed deposit insurance is thus seen by critics as just a bailout scheme for depositors.

What lies ahead?

The increase in deposit insurance coverage is likely to increase the level of confidence that depositors have in the banking system. It will also offer some relief to the depositors who have found their money stuck in a number of cooperative banks such as the Punjab and Maharashtra Cooperative Bank. However, apart from boosting confidence in banks, increased deposit insurance coverage may also lead to higher risk of moral hazard as more depositors will be protected by the government. To rein in this risk, regulators such as the Reserve Bank of India may choose to regulate banks more aggressively.

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Printable version | Sep 23, 2021 6:12:52 PM |

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