Zero bank failure is the best deposit insurance policy

Against this backdrop, RBI deputy governor Rajeshwar Rao’s recent speech on deposit insurance at an event is timely in more ways than one. Rao drove home the unassailable advantage bank deposits have over almost every other kind of investment: insurance. 

This provides a backstop (currently limited to ₹5 lakh) for any loss to depositors due to bank failure. That’s at the individual level. At the macro level, deposit insurance plays a key role in instilling confidence in the banking system, enabling it to lend to the real sector and thereby keep the wheels of the economy well-oiled and running. 

The case for deposit insurance is, therefore, beyond dispute. Especially since technology and digitalisation of financial services, coupled with the (destructive?) role of social media in amplifying fear, means bank runs can be triggered more easily. This was brought home dramatically following the collapse of some prominent banks in the US and Europe in 2023. 

Though the root cause of these failures might have varied—from liquidity mismanagement to flawed business models and failure to diversify across different classes of depositors—the role of uninsured deposits and related to that, the adequacy of deposit insurance coverage, came in for renewed attention soon after.

Modern banking is based on the fractional reserve system, wherein banks retain a fraction of their deposits and lend the rest. Trust, or depositor faith, that the bank will be able to repay their deposits ‘on demand’ is fundamental. The moment this faith is broken, the result is a run on the bank, which, if not nipped in time, can lead to a collapse. 

Sure, full insurance cover for deposits may seem ideal for depositors and help avoid bank runs. But this is a suboptimal solution given the associated moral hazards and financial non-viability. So, much as it is desirable to insure bank deposits, there are many tricky issues that regulators must first navigate. 

Should deposits be insured in their entirety? What about the resultant moral hazard? Can cover be extended selectively to some sections of the population such as senior citizens and small depositors, as deputy governor Rao suggests? At what cost? Should the cost (premium paid by banks) have any relation to banks’ risk profile? 

The primary objective of risk-based premium is to incentivise banks to avoid excessive risk-taking, minimise moral hazard and introduce greater equity in the premium assessment process. Growing digitisation poses additional issues. 

How should digital deposit-like products be covered? How can banks be risk-proofed against climate change impacting credit quality and thus borrower repayment capacity?

In India, deposit insurance is administered by the Deposit Insurance and Credit Guarantee Corporation (DICGC). As of 31 March 2024, 97.8% of all accounts were fully protected, though as a percentage of total deposits, the cover is less since the bulk of deposits have small balances. 

Thanks to state-ownership of a large part of the banking system, bank runs and related failures, other than among relatively small co-operative banks, have been few and far between in India. But that could change. It is imperative that we keep ourselves ‘future-ready’.