Is full deposit insurance the best way for banks to restore depositor confidence?

As India’s finance minister urges banks to accelerate deposit growth amidst a widening credit-deposit gap, there is increasing debate over whether enhancing deposit insurance to cover the total amount of deposits is the right strategy to win back depositor confidence.

While full deposit insurance may seem straightforward, a closer examination reveals significant risks that can undermine the stability of the banking sector and the broader economy.

India’s banking sector is facing a critical structural imbalance. The recent surge in bank borrowings, which has now surpassed ₹9 lakh crore, highlights the persistent issue of credit growth, consistently outpacing deposit growth. Since April 2022, this disparity has forced banks to increasingly rely on market instruments, such as interbank repos and infrastructure bonds, to meet their funding needs.

As borrowing costs rise, banks have little choice but to pass these costs onto consumers by increasing lending rates. This could dampen consumer spending and business investment, potentially slowing the post-pandemic recovery.

Moreover, inflationary pressures could further complicate the economic landscape as banks adjust deposit rates upwards to attract more deposits.

Finance minister Nirmala Sitharaman has been vocal about the need for banks to innovate and attract more deposits to close this gap. "The growing gap between credit and deposit growth poses significant challenges for our banking system. Banks must explore innovative strategies to attract deposits and ensure they can continue to support economic growth effectively," she stated at a recent financial summit.

Amid these challenges, insuring the entire deposited amount—beyond the current ₹5 lakh limit—has gained traction. Proponents argue that such a move could restore depositor confidence, particularly in light of past banking crises. However, the implications of this policy shift extend far beyond simply reassuring the public.

The most immediate impact of full deposit insurance would be a substantial increase in insurance premiums that banks would be required to pay to the Deposit Insurance and Credit Guarantee Corporation (DICGC). Currently, banks in India pay a premium based on their total deposits, with coverage capped at ₹5 lakh per depositor. Expanding this to cover all deposits would necessitate a significant hike in these premiums. Given that banks are already paying premiums based on the current coverage of ₹5 lakh, moving to 100 per cent coverage could lead to a significant hike in these rates, possibly by 20 per cent or more, as indicated in the DICGC Bill provisions.

Banks typically pay a minimum of 10 paise per ₹100 of their total deposits as insurance premiums to the DICGC. This rate has been increased to a minimum of 12 paise and a maximum of 15 paise. The premium is payable in advance for each half-year (April to September and October to March). Banks have to pay the premium within two months of the commencement of each half-year.

If a bank delays the premium payment, it has to pay penal interest at 8 per cent above the bank rate from the beginning of the financial half-year until the date of actual payment. The premium is charged on the total assessable deposits of the bank as of the last day of the preceding half-year. For example, for the half-year starting April 2023, the premium will be based on deposits as of September 30, 2022.

Insuring the entire deposit base would also compel banks to significantly strengthen their risk management practices. With larger insured liabilities, banks might adopt more conservative lending practices, which could limit their ability to extend credit, especially to higher-risk borrowers. As of March 2024, total assessable deposits in India were reported at approximately ₹210 lakh crore. If all these deposits were insured at 100 per cent, the total potential liability for the DICGC would be the full amount of these deposits. This could lead to an enormous financial obligation, necessitating a robust funding mechanism to ensure the DICGC can meet its liabilities.

Moreover, the Reserve Bank of India (RBI) might impose stricter capital adequacy requirements to ensure banks have sufficient buffers to cover potential losses, adding further pressure on banks already dealing with rising borrowing costs.

One of the most significant risks of 100 per cent deposit insurance is the potential for moral hazard. With the assurance that all deposits are fully insured, banks might engage in riskier lending practices, knowing that depositors are protected regardless of the outcome. This could destabilise the financial system, leading to higher default rates and larger payouts from the DICGC.

Additionally, full deposit insurance could exacerbate systemic risks. If depositors perceive certain banks as safer than others, there could be a significant shift of deposits from weaker to stronger banks, potentially triggering liquidity issues and even bank failures.

Given these potential pitfalls, the question arises: Is full deposit insurance the best way to restore depositor confidence? While protecting all depositors might be appealing, the long-term implications for the banking sector and the economy could be far from beneficial.

M Rajeshwar Rao, RBI deputy governor, highlighted the need for a balanced approach, stating, "While increasing deposit insurance may offer short-term reassurance to depositors, it is crucial to consider the broader implications for the banking system’s stability. We must ensure that banks remain disciplined in risk management and avoid creating a moral hazard."

Rather than expanding deposit insurance coverage, a more balanced approach might involve strengthening regulatory oversight, improving transparency in bank operations, and encouraging banks to adopt more robust risk management practices. The current ₹5 lakh insurance limit, increased from ₹1 lakh in 2020, already provides significant protection for small depositors.