A CASE FOR HIGHER DEPOSIT INSURANCE

The world financial market is facing one of the worst crises since the Great Depression of the 1930s. The $700-billion bailout, which some analysts are calling “cash-for-trash”, has barely calmed the international financial market, which is still coming to the grips with the huge fallout of the sub-prime crisis.

Unlike the earlier Savings and Loan Association crisis of the 1980s and 1990s in the US, the present debacle is still playing out, not only in Europe but also in Asia, including developed countries such as Japan and emerging countries such as China and India. It was widely believed by experts the world over that deposit insurance would avert this kind of crisis but it has not. However, it has surely minimised the run on the banks that would have led to a repeat of the 1930s.

Deposit insurance was seen as a measure of protection for depositors, particularly small depositors, from the risk of loss of their savings, arising from bank failures. The purpose was to avoid panic and promote greater stability and growth of the banking system — what in today’s world is termed financial stability.

But in the midst of a crisis in the global banking system, the concern is rather more critical — for many, a matter of survival or otherwise. The common man’s real concern is whether the insurance actually works.

Deposit insurance is at different levels in different part of the world. In India, deposits were covered, in the first Act of 1962, only to the extent of Rs 1,500 — the maximum amount payable was revised upwards to Rs 5,000 from January 1, 1968; to Rs 10,000 from April 1, 1970; to Rs 20,000 from January 1, 1976; to Rs 30,000 from July 1, 1980 and now to Rs 1 lakh from May 1, 1993. Since then, it stands at Rs 1,00,000 ($2,500).

The Government charges a premium of 5 paise, later raised to 10 paise for Rs 100. This covers a customer’s deposit, plus interest per bank in all the branches of the bank, up to a maximum of Rs 1,00,000. If one has an account in more than one bank, he is entitled to cover for another Rs 1,00,000 with each of the banks.

How safe?
As the world is coming to terms with the latest financial crisis, the Indian stock market has lost more than Rs 1,60,000 crore in value. In India, the banking sector has been affected more than the others.

The question being asked by the ‘aam aadmi’ (common man) is: “Is my deposit safe with the banks?” Despite the assurance by the RBI and our Finance Minister, the answer is only relative ‘Yes’, and not an absolute ‘Yes’. Even though our deposits with the banks are reasonably secure it is only due to such assurances, not because of any legal obligation of the fund or the Government.

Deposit insurance, as we know it, was introduced in India in 1962. India was the second country in the world to introduce such a scheme — the first being the United States in 1933. After the setting up of the Reserve Bank of India, the issue came to the fore in 1938, when the Travancore National and Quilon Bank, the largest bank in the Travancore region, failed.

The banking crisis in Bengal between 1946 and 1948 revived the issue of deposit insurance. It was in 1960 that the failure of Laxmi Bank and the subsequent failure of the Palai Central Bank catalysed the introduction of deposit insurance in India. The Deposit Insurance Corporation commenced functioning on January 1, 1962. In 1968, the Deposit Insurance Corporation Act was amended to extend deposit insurance to ‘eligible co-operative banks’.

The 1960s and 1970s were a period of institution-building. 1971 witnessed the establishment of another institution, the Credit Guarantee Corporation of India Ltd (CGCI). In 1978, the DIC and the CGCI were merged. After the merger, the focus of the new entity, the DICGC (Deposit Insurance and Credit Guarantee Corporation), shifted to credit guarantees.

This owed in part to the fact that most large banks were nationalised. With the financial sector reforms initiated in the 1990s, credit guarantees have been gradually phased out and the focus of the Corporation is veering back to its core function of deposit insurance, with the objective of averting panics, reducing systemic risk, and ensuring financial stability.

International practice
The UK has just raised its deposit insurance cover from 30,000 to 50,000 pounds sterling. Ireland recently guaranteed deposits of its six largest lenders. Some countries provide unlimited coverage in response to a crisis. Malaysia, Thailand and Indonesia did so in response to the 2003 crisis. Some countries, such as Japan and Mexico, had unlimited coverage, which was revoked after the crisis seemed to have abated.

The US is actively debating raising the limit from $100,000 to $250,000. Even with the recent increase in the limit of the deposits in various countries, a lot of deposits fall outside the safety net. Britain’s new limit will still leave about two-fifths of the cash in deposits uninsured.

America’s proposed change would do no more than reduce the part of the deposit base that is unprotected from 38 per cent to 27 per cent. The idea of a quarter or more of a big bank’s deposit base being wiped out is politically unthinkable. Indeed, when Wachovia, America’s fourth-largest commercial bank by assets, was rescued this week, the FDIC created a structure that protected all deposits. It has done so with other banks, too.

It is time the RBI and the Centre took another look at deposit insurance in India. When the Government has increased the annual income level of the ‘creamy layer’ to Rs 4.5 lakh, it is imperative that the RBI increases the limit to at least Rs 500,000 as the minimum deposit amount to be covered by insurance in the current context.

Raise the limit
The Government has to review, like other countries, an increase the insurance limits to avoid the flight of money too. India should also consider introducing optional co-insurance that is available in a few countries that will offer depositors the option to purchase additional cover by collecting additional premium from the depositors over the statutory limit of the deposit’s tenure, so that the tax-payers alone are not saddled with paying for the banks’ and big depositors’ possible bailouts in the future.

It was also felt that an additional purpose of a deposit insurance scheme would be to increase the confidence of depositors in the banking system and facilitate the mobilisation of deposits to enable growth and development. The traditional criticism of such insurance, however, is that it may indirectly encourage banks to take more risk. Hence, it is imperative on the RBI to ensure that the banks do not speculate, like the financial institutions in the US did.

Even after collecting the premium on all deposits over the set limit, it may not, under all circumstances, be possible to cover all kinds of bankruptcy. Even in the US, FDIC’s available funds, including untapped credit lines from the Treasury, are equivalent to just 1.5 per cent of total deposits of commercial banks. Ultimately, if the public thinks that multiple failures of big banks are likely, only the government can offer a credible guarantee to infuse confidence in the banking system.

Source: The Hindu Business Line