Safe deposits: Time to substantially increase insurance cover limit

As reported by this newspaper on Monday, the Union government is considering increasing the limit for bank-deposit insurance from the current level of ₹5 lakh. Although the final decision has not yet been taken, the limit might be doubled to ₹10 lakh. Deposit insurance is provided by the Deposit Insurance and Credit Guarantee Corporation, which covers all forms of deposits in commercial and cooperative banks. The fact that the government is mulling over increasing the ceiling for deposit insurance must be welcomed. As things stand, although about 98 per cent of accounts in insured banks are covered, only about 43 per cent of the accessible deposits are protected. Thus, increasing the limit of insurance will make deposits safer.

 

Since policymakers are still in the process of increasing the limit, they would do well to take into account factors such as the rapid adoption of technology among customers and recent global developments. It is worth noting that banking is an inherently unstable business, which is why deposits are insured. Banks lend for longer tenures on mostly short-term deposits. No bank is likely to be in a position to return deposits if all depositors demanded at the same time. Therefore, even a rumour of a bank run can actually lead to a bank run. Deposit insurance ensures that depositors do not rush to withdraw and worsen the situation in times of stress. However, if the insurance limit is too low, it can defeat the intended purpose. Thus, it is regularly increased. The limit was increased from ₹1 lakh to ₹5 lakh in 2020.

 

Given the widespread adoption of technology, it is now possible for bank customers to transfer funds at any time of day without visiting a bank branch, which can exacerbate the problem during times of crisis. It is, therefore, important to substantially enhance the deposit-insurance limit to effectively eliminate the risk of loss for individual depositors in the event of a bank failure. This is not only important from an individual depositor’s point of view but will also help improve banking stability. In an interconnected financial system, panic can spread quickly and create real liquidity risks even for healthy banks. The 2023 Silicon Valley Bank crisis in the United States (US) is a case in point. As the panic spread, the authorities concerned announced that all deposits would be protected, which helped avert a wider banking crisis. Even the US President intervened to assure depositors.

 

The basic reasoning in favour of increasing the deposit-insurance limit substantially is that an individual depositor should not be expected to analyse bank balance sheets before making deposits. Having a bank account is a basic modern need. Ensuring the safety of deposits should be the responsibility of the state, which can do the job through the banking regulator. This exception can be made only for bank accounts and no other financial instrument, where an individual is willing to take risks for higher returns. A potentially unstable banking system can be detrimental to the smooth functioning of the economy and affect longer-term economic prospects. However, on the flip side, a higher insurance limit can encourage bank management to take higher risks because deposit safety is guaranteed. This is a real possibility and must be addressed through better regulation and supervision. In a large economy, it is still possible that banks can come under stress. However, individual depositors should not be expected to pay a price.