Do Indians need insurance for bank deposits?

What is the need to increase the value of deposits that will be insured from ₹1 lakh to ₹5 lakh?

Amiyatosh Poornanandam: There are two parts to this answer. One, if we look within India, a limit of ₹ 1 lakh was fixed several decades ago. Now, if you do a simple calculation based on the inflation rate, the ₹1 lakh limit set in the 1990s has become woefully inadequate when adjusted for inflation. And second, if you look at international standards and compare the insurance limits, ours is still very low compared to many comparable economies. For example, think about South Korea and Brazil. That’s well below the level we see in the UK and the US, of course, you can’t compare figures for different countries looking at the difference in purchasing power and all that stuff, but broadly speaking, we have right now Also the amount of deposit insurance is less as compared to other countries. So, by raising the limit to ₹5 lakh, we are headed in the right direction.

We need deposit insurance because we want to assure the depositors that if a bank goes down, they need not go to the bank. They can keep their money in the bank, and the bank can continue to operate without any financial trouble. So, it’s a combination of these things.

Amol Aggarwal: This is a move to try to instill more confidence in the banking system. From a historical point of view, this whole discussion on deposit insurance in India began when we saw several bank failures, which led to attempts to stabilize the banking system. In the 1930s, America established deposit insurance. India established deposit insurance in the 1960s to deal with bank failures. So, in many ways, there’s a history lesson here, too, that every time your banks fail in a big way, the central bank does something about deposit insurance.

How does the deposit insurance system in India compare with other countries?

Amiyatosh Poornanandam: I don’t think anyone has ever lost money in any scheduled commercial bank in India. So, this means that India actually has 100% insurance. Hence, the depositors do not lose money. It’s just that the guarantee is not explicitly provided. And that leads to its own perversions. This is a slightly nuanced answer. If you ask, hey, how does deposit insurance in India compare to other economies, the answer is that this limit of ₹5 lakh is very low compared to other countries – which is six to six in comparison to the situation. 10 times less. comparable economies. But depositors in India do not have to lose money. There can be delays, and it can be quite expensive. So, there may be a lot of liquidity risk but there is no credit risk as the government always comes and saves the banks.

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If nobody’s money goes, doesn’t it satisfy the depositors? They have no incentive to do any due diligence before submitting. How do you solve that problem?

Amol Aggarwal: It’s all about being careful and trying to figure out which bank is riskier… If you look at other financial products, you’ll need to figure out ways to protect yourself as an investor. So, what is it about bank deposits that need to be insured? Now, I understand that the stability of the banking system is important, but so is the stability of the debt markets, equity markets and all kinds of financial markets. And here we have 100% deposit insurance, so people are not really doing their due diligence and hence there is nothing disciplining the investors. Even the premium that banks pay to insurance agencies to deposit is a flat premium. So, it basically means that whether you are a risky or a low risk bank, both pay the same premium. It doesn’t make any sense. We need to move to a more risk-adjusted premium model. The sooner we get there, the better, because then somehow the risk information will reach the depositors sooner and they will be more wary of investing money.

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Amiyatosh Poornanandam: Absolutely. We need risk-based deposit insurance premium, which is missing in India. When you don’t have that, it’s too much to ask a retail depositor which bank they invest in. If a bank offers a high interest rate and there is a reasonable expectation that the government will effectively come and kick them out, investors will be tempted to go to that bank. So, I do not think that under the current policy, investors will be wise enough to locate good banks. Investors, in fact, will eventually migrate to 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 remove distortion is to go with risk-based pricing. And second, there should be some kind of restriction on risk taking by the banks themselves. Otherwise, it is going to be a huge cost to the taxpayers. Anyway, I think it’s too much to ask depositors to be prudent when they deposit their money. I don’t think it will work. Better monitoring is needed.

How likely are private insurers to insure bank deposits? Will private insurance companies really be willing to take such a risk? Or would they be wiser?

Amiyatosh Poornanandam: Look, here’s the thing: Who will insure the insurer? This is the whole idea behind deposit insurance. This comes into play when panic strikes, like in 2008, when everyone was panicking about the financial sector and wanted their money back, leading to a self-sustaining crisis. Now, in that scenario, private insurance might not work because people may think that the private insurer will go bankrupt. This is where the power of the government comes in as 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 all about panic in the market. And when it is about the panic in the whole market, the thought that any other market participant will be able to take the risk which I think is very optimistic. US In the U.S., you have some small portions of private insurance but these are not on the scale that we need.

Amol Aggarwal: It is too much to imagine that private insurance can provide confidence during a crisis. In times of panic, it is usually the state that has to come to get people out. We saw in the 2008 crisis that the US, generally seen as a more market-driven financial system, eventually had to be bailed out by the government. And, of course, there is a considerable difference between such thinking as the free market Austrian school of economics and the more interventionist Keynesian school which thinks that government can and should work. In India especially, the RBI has done a great job of regulating the system.

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Amiyatosh Poornanandam: I am a firm believer in free-market economics, but I believe that when it comes to managing panic, this is what the government should do. But at the same time, deposit insurance must be reasonably priced, and risk must be properly monitored. See what happened to AIG in the 2008 financial crisis. It was insuring a group of financial products written by Goldman Sachs and other private banks. Finally, in 2008, the very survival of AIG became very questionable. Ultimately, the US government had to come out and save them. So, if you look at the evidence, it always goes back to ‘Who will insure the insurer?’ And we will always face that risk of the insurance company going out. what happens then? I think it should be the job of the government to manage this issue.

What exactly do you see as the role of RBI in regulating banks given the complacency of the depositors?

Amol Aggarwal: DICGC is basically owned by RBI. So, there are quite a few RBI officers working in the DICGC, and there is a lot of buzz and thinking in 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 who criticizes when a bank is in trouble. In the US, by contrast, the Federal Deposit Insurance Corporation also plays a role in resolving troubled banks, with the Federal Reserve not playing an active role in the resolution process other than lending to the troubled institution. I think RBI is campaigning about financial literacy and all these things. I think it should start to lead to the point that not all banks are the same and people should be careful. But then again, financial literacy campaigns are useful but only in a few pockets.

Amiyatosh Poornanandam: What needs to be done, and where I think RBI can do a lot and add a lot of value, is that it can stay a little ahead of the problem. So, when these bank failures happen, be it a co-operative bank or any other bank, there are a lot of signs of failure which lead to distress. Often those warning signs are missed by regulators. As I often like to say: Regulators are always a few steps behind banks. Banks innovate and are always at the fore in the game of creating new financial products. But regulators are still always playing a catch-up game in terms of ascertaining the actual level of risk taken by banks. So, I’m going to go with it that the RBI and other regulatory agencies really need to be on top of accurate risk models, disclosure of that information and prompt action before a bank fails. This is difficult because you need to have a good model to figure out which bank is under stress. Therefore, the discipline of the depositors has to go hand in hand with the improvement of the risk management system across the board.

Amol Agarwal is an assistant professor of economics at Ahmedabad University; Amitosh Poornandam is Professor of Finance at the University of Michigan