Mumbai: The crisis at the Punjab & Maharashtra (PMC) Bank, which left depositors high and dry, has led to a renewed clamour to raise the insurance cover for bank deposits in India. The government has signaled that the cover could be raised, partly to smooth the passage of a modified Financial Resolution and Deposit Insurance (FRDI) bill, shelved earlier because of depositors’ concerns over the fallout of bank failures.

Raising the insurance cover may seem a sensible strategy to allay depositor concerns over the fallout of bank failures. Yet, the costs of such a move may outweigh the benefits, a Mint analysis of India’s experience with deposit insurance suggests. A more cost-effective and prudent option would be to institute differential premiums based on riskiness of banks.

India is one of the few large economies around the world that has a uniform insurance premium for deposits across banks. At a deposit insurance cover of 1 lakh, India’s cover also appears relatively low.

However, it is worth noting that India is also poorer than most other large economies. Benchmarks on insurance cover set by the International Monetary Fund (IMF) prescribe two main features. One, it should have a distribution that covers 80-90% of number of deposits, and 20% of their value. Data from Deposit Insurance and Credit Guarantee Corporation (DICGC) report 2018-19 shows India’s limit covers 92% of all bank deposits and 28% of their value, in compliance with IMF’s 80-20 rule.

Second, the IMF suggests that the cover should ideally be one to two times the per capita income of the country. On this metric, India’s cover appears lower, with a 25% gap between the cover and India’s per-capita income as of fiscal 2019.

But it is worth noting that unlike most other large economies, two-thirds of bank deposits in India are parked with the Public Sector Banks (PSBs). This is in contrast with private sector led banking models of advanced economies.

An explicit guarantee in form of deposit insurance becomes needless in case of PSBs, which are deemed ‘too big to fail’ and have the sovereign acting as their biggest insurer.

It is the cooperative banks, which regularly suffer and frequently fail due to lack of regulatory supervision, which need explicit guarantees. To bring cooperative banks within the sole purview of the Reserve Bank of India (RBI), proposals to amend the Banking Regulation Act also seem to be in the pipeline.

The rise in India’s deposit insurance cover 25 years ago was triggered by the collapse of Bank of Karad, in 1992. While it may look tempting to treat similar sickness with the same old prescription, the hike neither cured repeated defaults, nor provided immunity to the depositors from the risk of losing their money. It is the pricing of the medicine (insurance premium) that needs a re-think.

At a flat 10 paise for every 100 of deposits, the deposit insurance premium paid by commercial banks is higher as their deposit base is bigger. A fair deal is ensured only when a low-risk highly rated well capitalised bank with a broad deposit base is charged a lower premium than a high risk lowly rated poorly capitalised bank with low deposit base. Absence of such a mechanism leads to perverse incentives for weak banks to keep taking risks so long as healthy banks are paying for their failure. This is what economists refer to as the problem of moral hazard, and this is what appears to have contributed to successive crises in cooperative banks.

In the past two decades, commercial banks have paid 13 times the premium charged to cooperative banks, data from the DICGC shows. In this period, no commercial bank has been allowed to wind up operations, while the cumulative claims settled for cooperative banks have risen from Rs. 72 crores to Rs. 4,822 crores. The burden of bad behaviour on the part of cooperative banks is being borne by the good banks, the state-backed banks, and ultimately by the taxpayer.

A number of committees that have looked into these issues have recommended risk-based premiums.
A number of committees that have looked into these issues have recommended risk-based premiums.

A number of committees that have looked into these issues have recommended risk-based premiums. The 2009 Rajan committee on financial sector reforms recommended a move to a risk-based premium while terming a 1 lakh cover as ‘generous’. In 2015, the Singh committee ran a simulation for a sample of 87 commercial and 50 scheduled Urban Cooperative Banks (UCBs) by classifying them into low, medium, moderate and high risk banks to come up with different rates of premia for each category.

A blanket increase in cover without restructuring premium rates might only end up increasing risk.
A blanket increase in cover without restructuring premium rates might only end up increasing risk.

The simulation applied a graded premium rate based on the multiple of base rate, changing as per the risk-ratings of the banks.

Differential premia, based on failure probabilities of banks, is likely to minimize moral hazard and nudge riskier banks to reform. A blanket increase in cover without restructuring premium rates might only end up increasing risk.

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