A stable banking system: Deposit insurance must be extended substantially

The Reserve Bank of India’s recent decision to impose curbs, including withdrawal restrictions, on Mumbai-based New India Cooperative Bank has once again brought attention to how individuals suffer due to the inefficiency and mismanagement in banks. Lives depend on savings deposited in banks. There is an ongoing debate whether India still needs cooperative banks, given the increased reach of commercial banks, enabled by technology. Another related area worth debating is whether individuals should suffer in such cases, which are essentially a result of inadequate regulatory oversight and mismanagement by the bank concerned. In this regard, to protect depositors, deposits of up to ₹5 lakh are insured by Deposit Insurance and Credit Guarantee Corporation. However, as a report in this newspaper showed on Tuesday, in terms of value, only about 43.1 per cent of accessible deposits are insured. The government is reported to be considering increasing the insurance limit. 

While the government would do well to decide in this regard as early as possible, there are several related issues worth considering. The business of banks is based on trust because bank balance sheets are inherently unstable. Banks usually have relatively short-term liabilities in terms of deposits and they issue loans for relatively long terms, creating an asset-liability mismatch. Further, while depositors can withdraw money relatively freely, banks cannot recall their loans as quickly. The adoption of technology has made management even more complicated. Depositors can shift their deposits in real time without even visiting a branch. Therefore, it is important for banks to be seen as healthy and stable at all times. Even a rumour of a run can bring the bank down. The ensuing panic can impact other banks, as was seen in the United States in 2023, starting with Silicon Valley Bank (SVB). A crisis of confidence can bring down the banking system, which has implications for the wider economy.

 

This is why banks must be properly regulated. However, mishaps cannot be entirely ruled out in a functioning market economy, with shareholder pressure to perform. It is thus important to be prepared. This is not to suggest that there are any such risks in the Indian banking system, but to provide enduring stability, it will be important that most bank deposits are insured. To begin with, insurance cover can be extended to all individual accounts. A depositor should not be expected to constantly evaluate the position of a bank. It is the job of the regulator and must be performed by the regulator. A bank account is a basic need for citizens and the state must ensure its safety. 

But there will be associated costs. These costs can be shared among depositors, banks, and possibly the government because the banking system’s stability is vital for the smooth functioning of the economy. If depositors know their money is safe, they will not rush to withdraw deposits and exacerbate the problem. Insurance was extended to all deposits in the SVB crisis in the United States, which helped prevent a bigger banking crisis. Increasing insurance coverage in India will also help level the playing field between private and public-sector banks. However, it can be argued that such a guarantee of safety will lead to moral hazard and encourage bank managements to take excessive risks, rendering the system more vulnerable. This will be a possibility. However, it is for the regulator to ensure risks are properly managed. It is important to note that safety cover should be extended only to bank deposits, not to other financial instruments chosen by individuals for higher returns.