A Premium On Uncertainty
In September 1996, a working group was set up under the chairmanship of K S Shere, former principal legal advisor of the Reserve Bank of India. The working group was given the brief of looking into the regulation and supervision of non banking finance companies (NBFCs) and considering the feasibility of introducing a deposit insurance scheme on fixed deposits accepted by finance companies. The deposit insurance scheme, if it were found feasible, would be modelled on the provisions of the U K Banking Act of 1987.
The fact that the group has already overshot the deadline of March 31 set down for it to table its report would have been overlookedbut for the fact that the CRB debacle has once again brought the issue of deposit insurance into the limelight.
Few would argue about the need for deposit insurance to offer protection to depositors, since fixed deposits are unsecured instruments that are not backed by a charge on assets. When a bank goes bust, the first charge of the claims go to the tax authorities. Similarly, in the case of a finance company, the assets will first be valued from the point of view of paying off tax dues. The next right of charge goes to those holding secured instruments, leaving very little for depositors holding unsecured deposits.
The problem is compounded by the fact that an NBFCs assets would stand considerably devalued as soon as it goes under. In the case of CRB, its total liabilities are of the order of Rs 600 crore, while the companys declared assets are reported to be just a third of this. At least part of the Rs 390 crore that the small depositor has lost in CRB could have been retrieved if fixed deposits offered deposit insurance guarantees. This is because the funds come from premia paid by the finance company to an independent body like the Deposit Insurance and Credit Guarantee Corporation in the banking sector. Deposits accepted by finance companies in the UK are covered by deposit insurance.
In spite of this, finance company executives are not so sure about the success of deposit insurance in India today. This has triggered a lot of debate on the issue: can deposit insurance
really provide an effective and adequate cover for fixed deposits that are, by definition, unsecured borrowings with a high risk/high return profile? Then again, would a deposit insurance backing lull more investors into a false sense of complacency about the safety of these high return instruments?
The deposit protection fund under the UK Banking act, 1987, provides partial protection for sterling deposits with the UK offices of authorised institutions in the event of the failure of such an institution. All authorsised institutions are liable to contribute to the sterling deposit protection fund, whether or not they accept sterling deposits. The Deposit Protection Board, comprising representatives from both the Bank and the contributory institutions, manages the fund. Monies constituting the fund are placed by the Board in an account with the Bank of England for investment in treasury bills.
A depsoitor, other than an authorised institution, is `protected to a maxiumum of 20,000 pounds in respect of the principal amounts of sterling deposits made with the UK offices of an institution, excluding secured deposits and deposits with an original maturity of more than five years. If the institution becomes insolvent, the depositor wilol be paid out of the fund an amount equal to 75 per cent of this `protected deposits, i.e. a maximum distribution of 15,000 pounds per depositor.
Close on the heels of the CRB scam, two of the leading NBFC associationsThe Association of Leasing and Financial Services and The Equipment Leasing Association have presented a paper on insurance of fixed deposits to the Reserve Bank of India (RBI).
Implementing these recommendations is not going to be easy, though. Says the vice president of a leading Mumbai-based NBFC: Monitoring NBFCs has never been an easy task. With almost 40,000 NBFCs in the sector, it is likely that at least some of them would continue to default on payments. Even if RBI insists on registration (this will help make deposit insurance compulsory), this will spawn an even larger grey market offering incredibly high returns. The basic issue of safety will continue to be defeated.
The other issue that has to be worked out first is the impact deposit insurance will have on the cost of funds of NBFCs, says Shekhar Sathe, senior vice president, Kotak Mahindra Capital Company. Even in the case of public sector banks, owned wholly or mostly by the government, there has been a demand that the insurance premium on deposits be linked to the risk profile of each bank to provide adequate cover (currently, the Deposit Insurance Act stipulates that all banks pay a standard premium of 5 paise per Rs 100 worth of deposits). The rating and realistic pricing of premium is going to be an even more dauntingand necessarytask in the case of NBFCs. Also, the Deposit Insurance Act will need to be amended if NBFCs are to be brought within its purview. All this may take time.
High insurance premia will also mean higher cost of funds for finance companies.
Needless to say, NBFCs will be tempted to pass these costs on. Since lowering the interest offered on deposits is not a workable solution in a highly competitive market, the other option could only be investment in riskier assets.And since there will inevitably be a ceiling on deposit insurance cover (in the case of banks, the ceiling is Rs 1 lakh per depositor), this will mean that FD s will continue to be largely unsecured, as before, points out a finance company executive.
One avenue that is being explored is the possibility of diverting funds earlier being used to pay broker incentives to pay for insurance premium.This is more feasible in the case of ill-managed NBFCs that were paying hefty incentives, since the sound ones have traditionally limited themselves to lower incentives.The logic behind this is that the need for brokerage would be reduced any way if deposit insurance were made compulsory. With insurance being offered, deposit funds would be expected to come in directly, and without too many additional monetary incentives. A classic example of this is Sundaram Finance, which was able to amass sizeable fixed deposits without the broker network.
Most finance company executives feel this could be one way of offering some security on FDs without incurring higher costs. But, this diversion exercise becomes meaningful only when the premium is based on the risk profile of an individual NBFC, which, today, is difficult to compute realistically.
Otherwise, it ends up penalising well-run NBFCs that were already observing good market practices, such as offering nil or low additional incentives. Also, most industry watchers expect the withdrawal of brokerage incentives in a large way to lead to a dip in deposit mobilisation volumes in semi-urban and rural areas. All these factors will hold up deposit insurance, finance company chiefs feel.
Says the senior vice president of a company requesting anonymity: The upshot of the matter is that ratingwhich has never been an infallible guide to investment in such unsecured instruments will cease to be of much relevance if deposit insurance is introduced. However, ratings will still continue to be relevant to the deposit component that is not covered by insurance.
Can deposit insurance be a panacea for deposit mobilisation even if it is introduced? No, aver most. The CRB saga is bound to make a dent in the credibility of non banking finance companies, at least for some time to come.``In the long run, however, as far as good companies go, the mobilisation should not be affected, says G C Garg, managing director, Lloyds Finance. At least one NBFC chief says one way (other than by providing deposit insurance) of projecting the image of safety would be to drop interest rates to project the low risk low return image, as banks have done. Perhaps one should aim at a branding which is similar to what exists in the banking sectorlow interest rates and safe deposits, he suggests. Paradoxically, this could be a double-pronged weapon projecting not just an image of safety, but releasing adequate funds (by way of lower interest rates) to pay for insurance premium, as well.
Niharika Bisaria