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Strengthening deposit insurance

The Government and the Reserve Bank of India must think of long term perspectives and introduce appropriate controlling mechanisms and not to be carried away by short-term gains, says R. S. Raghavan.

IN TODAY'S context of insecurity all round, discouraging market sentiment, dismal performance of mutual funds in the recent period, scams everywhere and declining interest rates, the common man, particularly in the middle class, is anxious for his sustenance. Safety of his hard earned savings is threatened. The recent debacle of the private finance companies as also banks in the co-operative sector causes anxiety. It is in this scenario people look for some comfort. The public sector banks have an advantage but is the money invested in banks, particularly in private sector, will be safe? New generation private sector banks offer competitive terms while age-old banks in the public sector are also provoked to face the challenges. One of the important comforts intended is `deposit insurance'.

U.S. experience

Before getting into the logistics of deposit insurance as prevalent in India, it will be interesting to know how it is in the U.S. — as an example and also, in the wake of globalisation, as these regulations in a substantial form are likely to be introduced in course of time in India. Between 1930 and 1933, the period of `Great Depression', 9,600 banks failed and the U.S. Government promulgated an ordinance on March 9, 1933 to suspend operations of 17,000 banks for six days; 12,000 banks reopened, but 2,000 were closed permanently and in terms of the relative legislation, Federal Deposit Insurance Corporation (FDIC) was created. Later, from 1985 to 1992, 1,304 banks failed. In all these cases, the FDIC as per mandate, paid the depositors in cash, true to its name. Over the period, these enactments were retuned to developments in the banking industry and today, FDIC is also a regulator, along with the Federal Reserve Board (like the Reserve Bank India here). Depositors in banks who are affiliated to FDIC, are protected to a value of $100,000. Accordingly, the public comprehend and do not enter a bank which is not a member of the FDIC. Such institutions suffer severe limitations in conducting business. Also, the rate of interest on deposits is tuned to these risks.

In the context of the failure of the Palai Central Bank in the early Sixties in India, a corporation to provide deposit insurance was established vide the DICGC Act, 1961. The intention was laudable in the then prevailing environs, to afford protection to depositors in banks. However, the concept of deposit insurance as practised in India or as it evolved itself later on, is a different story altogether. In the context of the insulated economy, (until 1990, the Government and the RBI were controlling the entire gamut of monetary and financial operations, more importantly on the foreign exchange front) banking was the virtual monopoly of the public sector banks. The share of private sector banks in deposits was minimal.

All banks including the public sector banks have been paying mandatorily, premium for deposit insurance cover (which was 5 paise per Rs.100 deposit, revised to 15 paise per Rs.100). Meanwhile, Credit Guarantee Corporation, established towards the end of 1970, for promoting small industries and small businesses, subsidised losses suffered by banks in extending financial assistance to these sectors. Post-Emergency, in such directed lendings, claims from banks were increasing and the Credit Guarantee Corporation was unable to sustain these claims. The resources at the Deposit Insurance Corporation's came in handy and thus the two organisations were merged to become Deposit Insurance and Credit Guarantee Corporation (DICGC); the premium on deposits collected was thus diverted (cross subsidisation) to meet the loan losses under the credit guarantee and within a short span, DICGC was threatened of resources. Given an option of the credit guarantee cover, all banks withdrew from the scheme of guarantee for loans while the insurance and premium on deposits was being continued mandatorily.

During this period, small banks here and there were crumbling. The RBI managed, through public sector banks, to assume the deposit liabilities of these small entities, thus avoiding public resentment and the depositors in these small banks were thus protected. A solitary exception was Bank of Karad where initial payment was made by the DICGC which was, however, made good later by Bank of India. In fact, it was (late) R. K. Talwar, the then chairman of State Bank of India, one of the most illustrious banker of unparalleled reputation, urged the Government/RBI to review the need for insurance of deposits in public sector banks!

In terms of Sec.16 of the DICGC Act, 1961, the liability of the Corporation (DICGC) in respect of an insured bank on whom an order for winding up or liquidation is made, "The total amount payable by the Corporation to any one depositor in respect of his deposit in that bank in the same capacity and in the same right shall not exceed Rs. 1,500". As permissible in the Act, the maximum amount payable was revised upwards to Rs. 5,000 from January 1, 1968; to Rs. 10,000 from April 1, 1970; to Rs. 20,000 from January 1, 1976; to Rs. 30,000 from July 1, 1980 and now to Rs. 1 lakh from May 1, 1993. It is to be observed that the limit of Rs.1 lakh is per depositor in a bank (bank which is under liquidation) which means all deposits of a person in different branches, if held, in the same capacity and in the same right. However, in practice, how in the present context any bank with a branch network, can consolidate a depositor's holdings in different branches is a tough question? Such a situation has not arisen, thanks to the RBI for managing the failing banks through public sector!

It is pertinent to mention that although the insurance cover as it exists, is limited to Rs.1 lakh banks are obliged to compute the premium on the entire deposits, that is, regardless of the amounts. Deposits eligible for insurance cover exclude inter bank deposits as well as deposits of government departments. Valuewise, the recent RBI report indicates that 72 per cent of the banks deposits are covered.

However, prompted by the Basel Committee recommendations and other pressures consequent to globalisation, the RBI is having a fresh look on the deposit insurance; the latest being the Finance Minister's indication in the recent budget proposals for revamping deposit insurance with regulatory powers on the lines of FDIC in the U.S. The RBI has on November 4, 1999, published a blue print for a reformed corporation, which is proposed to be named as the Deposit Insurance Corporation (DIC), with the following functions.

"... insurance of bank deposits as defined; maintenance of adequate bank insurance funds; administration of risk related deposit insurance premium as prescribed from time to time, which in turn, would necessitate the corporation to monitor the health of the insured banks on a continuous basis; play a proactive role in resolving a fragile/insolvent bank expeditiously when it is a going concern rather than a gone concern on least cost basis so that the viability and stability of the financial system is not affected and build an adequate capital base for itself to undertake the above mentioned tasks".

The Basle "Core Principles" identifies `compliance with laws' as well as `safety and soundness concerns' as the preconditions for `effective banking supervision'. This is where the FDIC's experience becomes very relevant... .".

This committee has explored the status of deposit insurance the world over and has deliberated to exclude CDs (certificate of deposits) from insurance; also, the committee recommends insurance in the case of liquidation of a bank being computed for a `depositor' rather than for a `deposit' (as recommended by the World Bank), the argument being that persons with multiple deposits may stand to gain by way of insurance! Also, premium for such insurance is recommended on the basis of the working of the banks — a bank which has low capital base is more risky and hence, higher premium and so on... How far these are implementable given the kind of infrastructure available with banks in India and the relative volumes of data to be collated and varied other complexities in the Indian situation is another one.

Adverting to the practice in the U.S., the individual insurance cover was $2500 which was increased to $100,000 in 1980. Since 1980, bank failures accelerated with more than 1,039 failures in the decade causing deep erosion of the FDIC's resources; since 1987, commercial banks in the U.S. were prescribed two different capital requirements, namely, a capital-assets (leverage) ratio and a risk-based capital ratio. In terms of the FDIC Improvement Act 1991, a bank's capital adequacy is assessed according to its leverage ratio (core capital/assets) — if the leverage ratio is greater than 5 per cent, it is well capitalised, similar gradings for four/three/two per cent and under — associated with each zone is a mandatory set of actions as well as a set of discretionary actions that regulators have to take.

The idea is to put teeth into minimum capital requirements and to limit the ability of regulators (which term includes besides, the central bank, namely, Federal Reserve Board, FDIC also) to show forbearance to the worst capitalised banks. Analysts blame such forbearance and regulator discretion for the size of the losses being borne by the taxpayers.

Widespread collapse of thrifts and the Federal Savings and Loan Insurance Corporation in the Eighties and the insolvency of the FDIC, prompted several developments culminating in the passing of FDIC Improvement Act to establish risk-based premiums (besides risk based capital requirements) since 1994 with simultaneous prescription of controls, namely, to impose higher capital ratios (to increase the shareholders stake and thus limit risky investments); and stricter bank closure rules. Since 1992, regulators must take specific actions — prompt corrective action — whenever a bank falls into a lower category and when the leverage ratio falls to 2 per cent or under, receivership is mandatory even before the book value ratio falls to zero per cent. (Here, in India many banks with negative capital are still operating... and further, the Government is subsidising for various other constraints). For the above controls, risk adjusted balance sheets are prescribed for banks in the U.S.

It is pertinent to mention that the above developments in the U.S. were contributing factors for evolution of Basle Committee recommendations (1988) at the international level. In India, these are being administered in doses since 1990's in the garb of liberalisation and opening of the economy! In fact, looked at from a different angle, it was sheer compulsion when the country's balance of payments came to a nought in the 1990s which prompted all these measures rather than brain wave of any individual or political party for that matter.

In the last few years, the RBI is exhorting banks on the need for risk management and gradually, capital requirements are prescribed for varied kinds of risks. It is unfortunate that as with the central banking institution, `risk management' continues to be on paper with bank managements: whatever happened to the will to implement the punitive aspects of risk management?

Even after several years, the loss making banks exist and the Government is prepared to dole out now and then, support through budgetary grants! One of the pitfalls in the macro perceptions, financial institutions like IDBI, IFCI and ICICI which were established statutorily and NBFCs until recently, were outside the scope of the central bank.

The Government and the RBI (as the central bank of the country) must think of long term perspectives and introduce appropriate controlling mechanisms and not to be carried away by short-term gains. (This aspect is yet to be perceived in India — the Government is having the total discretion to distribute/subsidise various sectors, including banking and recently UTI also, to cover up the blames, and political fallouts and the entire burden is shifted to public in raising taxes, whether it is income tax or excise duties. Lack of public comprehension on these aspects is the key for successive governments, whether it is State/Central, to bury their skeletons, inactions, inefficiency including losses from public enterprises, the RBI and latest, financial institutions and the like.).

In the U.S. again, insurance is also termed as a financial institution as also thrift associations, mutual funds with all the risk based capital requirements and the FDIC cover.

Insurance is privatised and the RBI should legislate to bring within its ambit, their resources, which was the omission in the past in the case of developmental financial institutions. The committee for revamping the DICGC has also recommended a separate corpus for co-operative banks, NBFCs. Similarly, PCAs (Prompt Corrective Action) for supervision of banks are proposed but how far and how fast these will be implemented? For instance, the blue print of RBI for revamping was in November 1999, more than two years, crucial in today's context, have gone by.

However, in today's context of market related economy, comprehension and skills and the most important aspect, will to implement measures to be enacted in the regulations are crucial. In reality, financial institutions in the U.S. are always under strict vigil and in such an environment, measures as detailed above are hyper sensitive to protect the public from disasters. We have a long, long way to go.

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