India needs to move to a risk-adjusted premium model so investors are more aware of the risks
At an event last week to mark the payment of over ₹1,300 crore to depositors in troubled cooperative banks, Prime Minister Narendra Modi flaunted his government’s revamped deposit insurance scheme. The scheme, which was upgraded through the Deposit Insurance and Credit Guarantee Corporation (DICGC) Amendment Bill, 2021, guarantees to compensate depositors up to a limit of ₹5 lakh within a period of 90 days from when a bank fails. At the same event, the Reserve Bank of India (RBI) Governor Shaktikanta Das warned depositors to be careful and avoid investing in risky banks just because they offer higher returns. In a conversation moderated by Prashanth Perumal J., Amiyatosh Purnanandam and Amol Agrawal discuss whether we need insurance for bank deposits. Edited excerpts:
What is the need to raise the value of the deposits that will be insured from ₹1 lakh to ₹5 lakh?
Amiyatosh Purnanandam: There are two parts to this answer. One is that if you look within India, the ₹1 lakh limit was set many decades ago. Now, if you do a simple calculation based on the inflation rate, the ₹1 lakh limit that was set in the 1990s has become extremely inadequate when adjusted for inflation. And two, if you look at international standards and compare the insurance limit, ours is still much lower than those of several comparable economies. For example, think about South Korea and Brazil. We are also way below the level that we see in the U.K. and the U.S. Of course, you cannot compare figures across countries in isolation given differences in purchasing power and all those things, but broadly speaking, we still have a lower amount of deposit insurance than other countries. So, by raising the limit to ₹5 lakh, we are going in the right direction.
We need deposit insurance because we want to give confidence to depositors that if a bank does go down, they don’t need to run to the bank. They can keep their money in the bank, and the bank can continue operating without any financial trouble. So, it’s a combination of these things.
Amol Agrawal: It is a step to try and infuse more confidence in the banking system. From a historical perspective, this whole discussion on deposit insurance began in India after we saw a number of bank failures that led to attempts to try and stabilise the banking system. In the 1930s, the U.S. set up deposit insurance. India set up deposit insurance in the 1960s to deal with bank failures. So, in several ways, there are history lessons here, too, that each time your banks fail in large numbers, the central bank does something about deposit insurance.
How does the deposit insurance system in India compare with those in other countries?
Amiyatosh Purnanandam: I don’t think anyone has ever lost money in any scheduled commercial bank in India. So, what that means is that in India, de facto, there is 100% insurance. So, depositors do not lose money. It is just that the guarantee is not provided explicitly. And that leads to its own distortions. It’s a little bit of a nuanced answer. If you ask, hey, how does deposit insurance in India compare with other economies, the answer is that this limit of ₹5 lakh is much lower than in other countries — in the range of six to 10 times lower than what is the case in comparable economies. But in India, depositors don’t lose money. There may be a delay, and that can be pretty costly. So, there could be a lot of liquidity risk but no credit risk because the government always comes in and rescues banks.
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If nobody loses their money, doesn’t it make depositors complacent? They have no incentive to do any due diligence before making a deposit. How do you address that problem?
Amol Agrawal: This whole thing of due diligence and trying to find out which bank is riskier… if you look at other financial products, you as an investor have to figure out ways to protect yourself. So, what is it about bank deposits that they need to be insured? Now, I understand that the stability of the banking system is important, but so is the stability of debt markets, equity markets and all sort of financial markets. And here we have an implicit insurance of 100% of deposits, so people are not really doing their due diligence and hence there is nothing disciplining investors. Even the premiums the banks pay to deposit insurance agencies is a flat premium. So, it basically means that whether you are a risky or a less risky bank, both pay the same premium. That doesn’t make sense. We need to move to a more risk-adjusted premium model. The sooner we get there, the better it is, because then somehow the information about risk will reach depositors sooner and they will be more wary of investing money.
Amiyatosh Purnanandam: Absolutely. We need risk-based deposit insurance premiums, which is simply absent in India. When you don’t have that, then it’s too much to ask of a retail depositor to be prudent about which bank they invest in. If a bank offers a higher interest rate and there is a reasonable expectation that the government will effectively come in and bail them out, then investors will be tempted to go to that bank. So, I do not think that under the current policy, investors will be discerning enough to figure out the good banks. Investors, in fact, will eventually migrate towards banks offering higher interest rates knowing that at the end of the day, the government will bail them out in case of trouble. The way to address the distortion is to go with risk-based pricing. And second, there has to be some sort of restriction on risk-taking by banks itself. Otherwise, this is going to be a huge cost to the taxpayers. Anyway, I think it is too much to ask of depositors to be prudent when it comes to where they deposit their money. I don’t think that will work. What needs to be done is better monitoring.
How likely are private insurers to insure bank deposits? Will private insurance companies actually be willing to assume such a risk? Or would they be more discerning?
Amiyatosh Purnanandam: Look, here’s the thing: who will insure the insurer? That is the whole idea behind deposit insurance. It comes into play when panic sets in, like in 2008, when everybody was panicking about the financial sector and wanted their money back, fueling a self-fulfilling crisis. Now, in that scenario, private insurance might not work because people might think that the private insurer will become bankrupt. This is where the might of the government comes in because the government has the ability to be the lender of last resort. So, unlike other insurance, like car insurance or health insurance, deposit insurance is about panic in the entire market. And when it’s about panic in the entire market, the thought that some other market participant will be able to assume the risk I think is too optimistic. In the U.S., you have some small pockets of private insurance but these are not at the scale we need.
Amol Agrawal: It’s too much to imagine that private insurance can provide confidence during a crisis. In times of panic, usually it’s the state which has to come in to bail people out. We saw in the 2008 crisis that the U.S., which is generally seen as a more market-driven financial system, had to be eventually bailed out by the government. And obviously, there is a fair bit of difference around this kind of thinking between the free-market Austrian school of economics and the more interventionist Keynesian school which thinks that the government can and should do the job. In India specifically, the RBI has done a done a decent job of regulating the system.
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Amiyatosh Purnanandam: I’m a firm believer in free-market economics, but I believe that when it comes to managing panic, it should be the government that should do it. But at the same time, the deposit insurance should be properly priced, and the risk should be properly monitored. See what happened with AIG in the 2008 financial crisis. It was insuring a bunch of financial products that were underwritten by Goldman Sachs and other private banks. In the end, AIG’s survival itself became very doubtful in 2008. Ultimately, the U.S. government had to come in and rescue them. So, if you look at the evidence, it always goes back to ‘who will insure the insurer?’ and we’ll always run that risk of the insurance company itself going bust. What happens then? I think it should be government’s job to manage this issue.
What exactly do you see as the role of the RBI in regulating banks given depositor complacency?
Amol Agrawal: The DICGC is basically owned by the RBI. So, there are quite a few RBI officials working in the DICGC, and there is a lot of discussion and thinking at the DICGC. But when it comes to bank failures, it is the RBI and not the DICGC that is playing a major role, so it is the RBI that comes under criticism when there’s trouble at a bank. In the U.S., in contrast, the Federal Deposit Insurance Corporation also plays a role in the resolution of troubled banks, with the Federal Reserve not playing an active role in the resolution process other than lending to the troubled institution. I think the RBI is running campaigns about financial literacy and all these things. I think it needs to also begin to drive home the point that not all banks are the same and people should be careful. But then, financial literacy campaigns are useful but only in a few pockets.
Amiyatosh Purnanandam: What needs to be done, and where I think the RBI can do a lot more and can add a lot more value, is that it could stay a little bit ahead of the problem. So, when these bank failures happen, whether it is a cooperative bank or any other bank, there are a lot of signs of the failure that build up leading to the crisis. Often those warning signs are missed by the regulators. As I often like to say: regulators are always a few steps behind the banks. Banks innovate and they’re always ahead of the game creating new financial products. But regulators are still always playing the catch-up game in terms of figuring out the true level of risk that banks have taken. So, where I’m going with that is that the RBI and other regulatory agencies have to be really on top of the precise risk model, the disclosure of that information and quick action before a bank fails. This is hard because you need to have a good model to figure out which bank is under stress. So, depositors’ discipline has to go hand in hand with improvement in risk management system across the board.
Amol Agrawal is Assistant Professor of Economics at Ahmedabad University; Amiyatosh Purnanandam is Professor of Finance at the University of Michigan