What happens if your bank fails? Decoding India’s deposit insurance scheme and ways to address its flaws

The deposit insurance scheme as it exists currently suffers from several practical and conceptual problems. From a depositor’s point of view the biggest problem is not so much the absolute amount of coverage but the lag with which the insurance company, the Deposit Insurance and Credit Guarantee Corporation (DICGC), pays up. In FY19 for instance, it took on average four years for DICGC to settle claims. But note that this period of four years is from the date of deregistration of a bank and not the date on which a bank defaulted (or the RBI imposed restrictions on deposit withdrawals). Imagine an insurance company settling health insurance claims several years after a fire caused damage or a medical procedure. At a 7 percent interest rate, a five-year delay means that the effective deposit insurance coverage is just over Rs 70,000 rather than the Rs 100,000 that the law says is the coverage. Not to mention the emotional trauma of waiting. If there is one single thing that needs to be changed about the deposit insurance scheme is the timing of insurance payment. DICGC should pay depositors when there is a default, not when the RBI orders the bank into liquidation. This is in keeping with the spirit of what a deposit insurance scheme truly implies.

But there are conceptual issues with the deposit insurance scheme as well. For one, the deposit insurance premium is the same for all banks. It does not differentiate between banks based on the underlying risk. An HDFC Bank or the State Bank of India pays the same premium for deposit insurance as a cooperative bank. The stronger banks thus overpay and cross-subsidise the weaker banks. There is also another type of cross-subsidy – one where the large depositors subsidise the smaller depositors. This is because while the insurance amount is capped at Rs100,000, the insurance premium paid to DICGC is on the entire amount of deposit.

But by far the biggest conceptual issue with the current scheme is around the pricing of the risk of a bank failure. The current insurance premium is 0.1 percent of deposits. This is not based on some statistical model nor based on the historical experience of bank defaults. The premium does not change based on the state of the business cycle (it is neither pro nor countercyclical). And as discussed above, the premium is the same irrespective of the underlying risk. This does not mean that the premium being charged is low. All it means is that we do not know whether the premium being charged, in aggregate, is too high or too low or about fair. For example, the current insurance pool with DICGC is around $14 billion as against a total insured base of about $500 trillion – so the insurance pool is around three percent of insured deposits. The insured deposit base of the most vulnerable section of the banking system, the cooperative banks, is more than 3.5x the insurance pool with DICGC. Is this adequate to cover the scenario of a banking crisis (on the liability side)?