Recent bank collapses have created more awareness and news about deposit insurance. So what is deposit insurance? In simple words, there is an organisation that insures our deposits in banks and in the event of insolvency, that organisation reimburses our deposits. But there’s a catch. Not all the money parked in our accounts is insured. There is a maximum limit for each individual. For example, in India, Deposit Insurance and Credit Guarantee Corporation (DICGC) insures a maximum of Rs. 5 lakhs per depositor per bank. So if you have more than Rs. 5 lakhs in a bank, then the amount over and above that is uninsured.

But why does this limit exist? Find the answer below. But before that let us go through some interesting facts and figures.

Share of Insured Deposits

The report Deposit Insurance in 2022: Global Trends and Key Emerging Issues, published by The International Association of Deposit Insurers (IADI) highlights that the proportion of insured deposits to total deposits is the highest in Europe followed by Asia. It also states that such proportion should be adequate i.e. ‘cover the large majority of depositors but leave a substantial amount of deposits exposed to market discipline’. More on this later.

Country-wise Deposit Insurance

Here is the chart showing the maximum deposit insurance limit for the major economies –

I converted all the local currency-denominated insurance limits to US dollars for standardisation. A few immediate observations are as follows –

1. India’s insurance limit (in absolute terms) is very low compared to its peers.
2. Developed countries have higher limits of insured deposits compared to emerging markets.

Relative Analysis

Nothing in the financial world can be analysed based on absolute amounts. We need to analyse the data in comparison with some other metric that provides context and makes analysis more interesting and insightful.

The best way to do that is to compare this data with the per capita income (PCI) of the country. The EMs have lower PCI and insurance limits while the DMs have higher PCI and insurance limits. I divided the deposit insurance maximum limit by the PCI. It gives us average insurance coverage. It tells us how many times of the average income are the deposits insured.

Here’s the chart –

Now our inferences differ from the previous one; i.e. –

1. India’s insurance limit is 2.5 times the per capita income. It means that even though the average income of an Indian is around Rs. 2 lakhs, the deposits amounting to Rs. 5 lakhs per depositor per bank are insured. This ratio is slightly lower than the EM average. But this average is skewed due to the very high insurance limit of Indonesia (28x). If we exclude Indonesia, the EM average is 2.7x. So, in that sense, we can say that India is around the EM average.
2. Overall, insurance coverage is very high for EMs compared to DMs. India is at par with Australia and France while Thailand, Malaysia, Brazil, China and Indonesia’s coverages are higher than the US. One should not get a sense that EMs are doing better than DMs. The analysis in such cases is a bit different. More on this in the later sections.
3. The range of coverage for DMs is very less (between ~1x and ~3x) compared to that of EMs (~0.5x to ~6x excl. Indonesia).

Moral Hazard and Incentives

Moral hazards and the role of incentives play major roles. The textbook definition of moral hazard is – “a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost.”

What will happen if there is no deposit insurance? There are two things that can happen if a bank fails and there is no deposit insurance.

Firstly, the government might intervene and announce a blanket guarantee of deposits thereby safeguarding all or most of the depositors. In this case, if the actions of the government show that it will always bail out depositors then banks may undertake more risky businesses in future. That will also make depositors careless about the bank’s functioning.

Secondly, the bank may be allowed to wind down which may create panic in society leading to a full-blown banking sector crisis.

Both measures and/or outcomes are not desirable. Therefore, there is a system of deposit insurance which stabilises the financial sector. Then, one might ask why the insurance is not applicable for all deposits without any limit. Deposit insurance without any limit is akin to the government giving a guarantee. Such a system will only create additional accounting entries without addressing the core issue.

If there is a limit, it safeguards some depositors. The panic and bank runs can be avoided. If the deposit insurance is very high vis-a-vis people’s income then that can do more harm than curbing the crisis. Banks can weed out profits and shift losses to the insurer (usually the government). Also, depositors will not have an incentive of monitoring the bank’s business.

Speaking of these economic principles, one cannot ignore politics and political incentives. In general, it removes the threat of widespread losses and bank runs and gives political stability. Increasing deposit insurance limits can be one of the ways through which politicians can send the message that they care about people’s money. That is the simplest way to assuage people without spending any penny now.

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(Note: A World Bank report has also measured the moral hazard issue. That itself is a deep rabbit hole. I have made some charts about that too, but was not able to understand the nitty-gritty, hence excluding them in this article. If anybody needs that data, I am happy to share it with you. Let me know in the comments below.)

EM vs. DM and Ideal Insurance Coverage

The 2007 IMF paper cites an incident when the US increased the deposit insurance limit. It states,

“In systems with explicit deposit insurance, the frequency of bank crises rises as the ratio of deposit insurance coverage to per capita GDP increases. When the U.S. raised its policy limits on deposit insurance from $40,000 to $100,000 per depositor per bank in 1980, coverage shot up to approximately nine times per capita GDP. Shortly thereafter, the 1980s U.S. savings and loan crisis ensued. Today, economists estimate that the likelihood of that crisis would have dropped by forty-three percent if the U.S. ratio had been the same as Switzerland’s (one-half of per capita GDP). More generally, countries with coverage of over four times per capita GDP are five times more likely to suffer bank crises than countries with coverage of under one time per capita GDP….Limiting deposit insurance coverage is even more important in developing countries, because banks in those countries tend to hold higher higher- risk assets on average than banks in developed countries.”

Therefore, in the above chart where we compared EMs’ and DMs’ insurance coverage, it is important to understand that the higher coverage ratio would create a moral hazard on the part of the banks leading to more risks in the banking system.

Thoughts

There is no ideal formula. The coverage should neither be too high nor too low. It needs to be implemented along with different measures such as increasing capital adequacy, improving risk models, strengthening institutions and abiding by market discipline.

That means deposit insurance should exist but must not be as high as seen in Indonesia today or in the USA in the 80s. In case of an adverse event, it will help most of the depositors. Economics textbooks preach that governments should not bail banks out. Instead, banks should be allowed to fail or liquidate or get acquired by a larger and stronger bank. That’s the market discipline. But this step is not welcomed everywhere. Lehmann Brothers collapsed and that created a worldwide crisis.

Therefore, there is a need to rethink such economic measures. Whether they hold true in this highly interconnected world? Is the current banking environment so vulnerable that it will face a crisis every decade? Should we assume that this is normal? Or should we change something to avoid crises in the future? And is that really possible?

These are fundamental questions which I am incapable of understanding, thus far from solving them. Nevertheless, there are certain things that can be addressed or at least be changed. We can change the role of deposit insurance. We can design deposit insurance premiums in such a way that banks become more risk-averse. Then, we can improve governance in banks and make them more accountable. Their clientele can be more diversified, unlike SVB. Their stress tests can be more robust and frequent. We can also institutionalise depositors’ role in monitoring the banking business. We can also bring climate change and fintech innovations in contingencies and risk modelling.

Many researchers and experts have suggested such changes. Maybe, this event could trigger these changes. Or maybe, not.

– Swapnil Karkare

Sources and Further References:

Deposit Insurance Database, World Bank, 2014

The Reversed Role of Chinese Deposit Insurance, econlife

Deposit Insurance in 2022: Global Trends and Emerging Issues, IADI

The Moral Hazard Implications of Deposit Insurance: Theory and Evidence, IMF, 2007