Why insurance cover for your bank deposits is necessary

The Union government recently passed a legislation which increased the limit of the deposit insurance coverage to Rs 5 lakh. Since then, I have received numerous phone calls from people regarding their deposits and whether they should keep bank deposits beyond this amount. Some have asked whether distributing the deposits across accounts would be a better strategy – or if they should instead look for other savings instruments. The phone calls from friends and family intensified post the RBI cancelling the license of a cooperative bank.

All your money is safe

It is therefore important to write on this subject, as I recognize many have become anxious, more so because of the present economic scenario of heightened uncertainty. But before we discuss the issue of deposit insurance, how it works etc, let us first recognize one simple fact – Your deposits, in any Scheduled Commercial Bank are as safe as any risk-free financial asset. That is, even if you have Rs 1 crores of savings in a single bank account – all your money is safe.

The reason it is safe is because of two reasons – for starters, scheduled commercial banks haven’t failed in India. Second, because of the systemic importance of these banks, there will always be an attempt to figure out a mechanism to resolve any solvency issues. In fact, most of these banks are subject to stiff regulations designed precisely for the purpose of early identification of stress so that appropriate action can be taken well in time.

Banking largely depends on trust; we deposit our money in a bank because we trust it to return our money when we need it. Banks then go ahead and lend that money to borrowers that they believe would return the money back. Sometimes, some borrowers don’t return the money and the bank books a loss. But that loss comes on its balance-sheet and eats into the equity – while depositors can still claim their amount in their account without any hassles. If depositors were unable to withdraw their money, there would be panic which would spread across the financial system – and there would be a bank run across all major banks thereby crippling the entire system. This is exactly what happened after Lehman Brothers filed for bankruptcy in 2008.

To give a recent example in India, Yes Bank faced several issues regarding their quality of disclosures, non-performing etc and it was witnessing a deterioration in its balance sheets. The RBI was quick to act, first by facilitating a change in management, and later by putting the bank under a moratorium and gradually putting in place a strong resolution plan that would revive the bank. As of today, all the depositors of Yes Bank know for a fact that despite a couple stressful weeks, their savings are 100% safe.

So, to cut the long story short, your (and mine) deposits are safe in a Scheduled Commercial Banks – even if they are beyond Rs 5 lakh. It is because of better governance, better regulation and to prevent a full-blown meltdown of the financial system. Of course, this creates a problem of moral hazard as depositors will not be careful about supervising their banks while banks too may continue to take on aggressive risk knowing that they will be bailed out. This is precisely why there are stiff regulations and oversight mechanisms in place across the world to correct for such situations – & to prevent banks to get to a point where they have to file for bankruptcy. Hopefully, India too will see these mechanisms strengthened over the coming years.

Why insurance is needed

The logical question then is why is there an insurance of deposits up to Rs 5 lakh if all the savings are safe?

Across the world, there are several deposit insurances schemes that are geared towards assuring depositors that their money is safe. Each country has a different limit on the amount of deposits that are insured. For example, in the US, the Federal Deposit Insurance Corp (FDIC) guarantees deposits up to $250,000 per person per bank.

The reason for this insurance is that should there be any troubles despite the strong oversight, regulatory provisions and resolution plan, then the depositors can be guaranteed a part of their deposits. In many cases, the regulators such as the RBI will impose a temporary ban on withdrawals while finding a bank with healthy balance-sheet which can take over the deposits thereby ensuring that all deposits are intact.

The situation of cooperative banks, however, may be different from Scheduled Commercial Banks. There has been an attempt to improve the oversight of RBI along with strengthening the regulatory mechanisms governing our cooperative banks. However, there are still concerns about their functioning, RBI’s resources to provide necessary supervision & the legal framework to push for takeovers by bigger banks. The expanded insurance should cover for most depositors of cooperative banks in the event of any financial stress, which will come as a relief to lakh of depositors, nonetheless.

We must, however, remember, that our financial system is well intact, and deposits are safe. There may be occasional troubles & restrictions on withdrawals, however, ultimately the RBI will attempt for a resolution to keep our savings safe. The focus should now be on ensuring a template to prevent a situation demanding for a resolution to exist in the first place.