Indian Parliament is expected to legislate on a rise in the amount of insurance for bank deposits from Rs. 100,000 to possibly Rs. 500,000 in its ongoing winter session. In this post, Gurbachan Singh takes a closer look and shows that the idea of raising the coverage under deposit insurance is a soft option. Prof. Singh suggests an alternative solution.
The basic idea of deposit insurance in India is quite familiar (Verma 2019). At present, the coverage is up to Rs. 100,000 for bank deposits; this amount was fixed in 1993 and in the meanwhile there has been considerable inflation and economic growth. Accordingly, the Parliament in its ongoing winter session is expected to legislate on a rise in this coverage to possibly Rs. 500,000. This argument in isolation makes sense but there is a deeper question.
The popular narrative takes the idea of deposit insurance for granted. However, the academic view has been quite different. In this post, I will take a closer look and show that the idea of raising the coverage under deposit insurance is a soft option; it does not address the root problems of non-performing assets (NPAs), bank losses, and risks for stakeholders.
In India, the issue of NPAs relates primarily to public sector banks (PSBs) and cooperative banks; it also relates to audits and regulation. Before we come to these important aspects, it will help to consider for the moment a benchmark case of an economy with only private commercial banks and a good legal-regulatory framework.
Basic economics of depositors’ safety
If banks are reasonably capitalised, well diversified and well run, depositors do not face any significant risk – at least not in normal times (more on this later). An important way to ensure that banks are indeed well managed is through the incentives of shareholders and their representatives in the management of banks. Shareholders (and other such investors) are junior claimants compared to the depositors. In the event of a possible bankruptcy and liquidation, such investors get zero gross return on their investment if any depositor loses even a very small amount that is due to her. So, there is an incentive for such investors or their representatives to ensure that the banks are well managed. We have here an interesting mechanism at work to ensure reasonably adequate safety for depositors in normal times.
In an abnormal time, there can be a systemic panic run on banks which can create a liquidity shortage that cannot be met by banks on their own; the liquidity issue can then become a solvency issue. There is a need for intervention here. However, what is needed is the lender of last resort1 (LLR) rather than deposit insurance. This will become clearer later. It is true that sometimes there can be a big recession or systemic crisis which is when there is, to begin with, a solvency issue for very many banks. However, this solvency issue warrants a high capital adequacy ratio2 rather than deposit insurance (Gangopadhyay and Singh 2000, Singh 2012).
It is true that though factors like LLR and capital adequacy norms can improve banking substantially; these cannot ensure 100% safety for depositors. This, it may be argued, is where some deposit insurance is required. Well, not quite. This is because deposit insurance has a high social cost besides the private cost to depositors; the social cost relates to moral hazard. It may help to consider the experience elsewhere in this context.
In the US, after the deposit insurance coverage was raised to US$ 100,000 in 1980, over the next 10 years, several thousand depository institutions failed; the cost to the government of paying up the depositors was more than 3% of a year's GDP (gross domestic product). Furthermore, deposit insurance led to higher leverage in the banking system; banks' assets increased to 10 or 12 times their equity (as compared to a figure of around four in the 1920s before the deposit insurance was first introduced in 1935). There were other adverse effects too (Cechetti 2008).
It is true that the US again raised the deposit insurance coverage to US$ 250,000 after, what has come to be called, the Global Financial Crisis (GFC) in 2007-08. However, this was in the background of runs on investment banks.3 Furthermore, such a change was accompanied by important structural changes under the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2011. That kind of a situation is not prevalent in India.
The situation in India
In India in recent months, there have been serious difficulties at the Punjab and Maharashtra Cooperative (PMC) Bank. This case has received considerable attention in the media. This is not an isolated case. Between 2009-10 and 2018-19, over 400 claims of deposit insurance from cooperative banks were settled (Business Standard, 2019). The public is worried – more so because ever since the Asset Quality Review (AQR)4 was started in 2015, there have been reports of large losses in banks. Now the public authorities in India are addressing that concern by the proposed legislation to raise the deposit insurance coverage. But that is a very soft option. The root problem lies in the state of affairs in banks in general and PSBs (and cooperative banks) in particular. It is these weaknesses that need to be addressed and there are ways to tackle the problems there (Sengupta and Vardhan 2019; Singh 2018, 2019).
The role of PSBs has been consistently declining in India since the early 1990s with the entry of new private sector banks in a phased manner. This trend is, it appears, likely to continue. It may accelerate with possible privatisation of some, if not all, PSBs in one way or another. It follows then that it is important to look at the proposed legislation from the viewpoint of future banking that is going to be increasingly in the private sector in India.
The Insolvency and Bankruptcy Code (IBC) came into being in 2016 in India. This is an important step. However, this does not cover banks. In 2017, the Finance Minister had introduced the Financial Resolution and Deposit Insurance (FRDI) bill in Parliament but it had to be withdrawn in 2018 due to the stiff opposition it faced. The bill provided for a bail-in clause whereby depositors' money could be converted to equity capital in the event of a serious difficulty in a bank. There was resentment against such a provision. The bill was eventually shelved. However, the need for a resolution process for a failed bank remains.
An alternative solution
A way out that is consistent with the theme in this article is that the capital adequacy requirement in banks is raised (instead of the coverage of deposit insurance being raised). This will provide a cushion for depositors who will face a much, much lower probability of the event in which the bail-in clause in the resolution process is invoked (Singh 2017). An increase in capital adequacy requirement has two effects. First, there is a greater possible loss for junior claimants like shareholders (and accordingly greater safety for depositors), given the business policies of the bank management. Second, the business policies and risk-taking behaviour of the management can usually get more conservative, if the capital adequacy norms are tightened. This too provides greater safety for bank depositors.
It is true that all the above policy suggestions can at the most lead to a situation in which we can be almost certain that there will be hardly any loss for depositors but we cannot be completely certain. However, note that in any case economic theory and the actual behaviour of people do not suggest that complete 100% safety is needed. Even so, it is true that the perception may be such that there is a demand or an expectation for 100% safety of bank deposits. In that case, it is interesting that there is a way out.
Besides bank deposits which are expected to be safe, there is another set of assets that people can feel comfortable with. These are long-term bonds and short-term bills issued by the sovereign entity, namely, Government of India. It is interesting that in India now there is easy access to such instruments through different (liquid) schemes run by mutual funds at a low cost; the returns on such funds are good, if not better than returns on bank deposits! There is then an even less compelling need for socially costly deposit insurance in banks.
To restate the obvious, there is clearly a risk in banking; if a bank does not recover adequate money from its loans and investments, it may not be able to repay its depositors in full. So, who bears the risk? Depositors, government, or shareholders? The proposed legislation that the Parliament is being presented with in the ongoing winter session is that the government should bear more risk and the depositors less so. However, we need not think in terms of just these two – the depositors and the government. There is the elephant in the room – at least in the context of profit and loss. This is the set of shareholders and their representatives who are, in fact, rewarded handsomely for management and taking risk. This is particularly true in the context of private sector banks in India many of which have been earning huge profits in India, given that they need to compete with PSBs that are for various reasons not very efficient and profitable. So, it is important that there is a change in policy so that the shareholders of private banks (and not the taxpayers) actually bear more risk. There is a rationale then for raising the equity capital requirement in banks. There may be a need to go beyond even what is required under Basel III capital adequacy norms; this may be done in a phased manner.
It may be felt that over time the Basel norms have been getting more and more stringent with the result that it is difficult to raise the capital adequacy norms any further. I would like to make two observations here. First, the argument that it is hard for banks to raise more capital and remain viable has been refuted at length (Admati and Hellwig 2014). Second, the world started with a very low capital adequacy requirement under Basel I norms. It is only relative to that initial low requirement that the current requirement appears to be high. It actually is not. Psychologists tell us that ‘anchoring effect’ plays an important role in people's perceptions (Kahneman 2011). The benchmark in this case is the low Basel I norms, which may have anchored people's belief in what is an appropriate capital adequacy norm. So, the conventional wisdom in this matter is understandable but it is not correct.
We do have a problem in banking. However, the solution is not to raise the coverage of deposit insurance as it leads to a serious moral hazard problem. Instead, the solution is to raise capital adequacy requirement in a phased manner; this alternative policy addresses the main issue involved.
- The central bank acts as the LLR if there is a serious issue of liquidity in the banking system or even in a very important bank; usually, the facility is for banks that are solvent but illiquid.
- Capital adequacy ratio is the ratio of a bank's capital in relation to to its risk weighted assets and current liabilities.
- Broadly speaking, there are two types of banks: commercial banks and investment banks (for example, Lehman Brothers). During the GFC, there was hardly any serious systemic run on commercial banks but that was not the case for investment banks. It was feared that runs could spread to commercial banks which is where the general public has bank deposits.
- The Reserve Bank of India (RBI) carried out AQR in 2015. This was to basically examine if the NPAs had been under-reported in balance sheets of banks. This indeed turned out to be true. This review brought to the forefront the huge NPA problem in India.
- Admati, A, and M Hellwig (2014), ‘The Bankers’ New Clothes – What`s Wrong with Banking and What to Do about It’, Princeton University Press, New Jersey.
- Business Standard, 2019, Beyond deposit insurance, Editorial comment, November 19.
- Cecchetti, SG (2008), ‘Deposit insurance, The New Palgrave Dictionary of Economics, second edition, ed.’ by Steven N. Durlauf and Lawrence E. Blume, vol. 2, Palgrave Macmillan, 444-447.
- Gangopadhyay, Shubhashis and Gurbachan Singh (2000), ‘Avoiding Bank Runs in Transition Economies: The role of Risk Neutral Capital’, Journal of Banking and Finance;24; 625-42.
- Kahneman, D (2011), ‘Thinking, Fast and Slow’, Allen Lane, London.
- Sengupta, R and H Vardhan, ‘How banking crisis is impeding India’s economy’, Ideas for India, 11 October, 2019.
- Singh, G (2012), ‘Banking Crisis, Liquidity, and Credit Lines – A Macroeconomic Perspective’, Routledge, Abingdon.
- Singh, G, ‘Large losses in banks: Going beyond bail-out and bail-in’, The Wire, December 10, 2017.
- Singh, G, 'Huge bank losses, frauds, and economic risks', Ideas for India, and Mint, March 9. 2018.
- Singh, G, 'How bank denationalization can be a solution to tackle slowdown woes', Financial Express, October 11, 2019.
- Verma, S, 'Explained: What is deposit insurance?' Indian Express, November 19, 2019.