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Why You Don’t Know Your Bank’s Risk Profile

Business World Nov 17, 2015

Rs 1 L: The sum a depositor is legally entitled to if his bank goes bankrupt By Raghu Mohan You may have crores in your bank account, but did you know that as a depositor you are legally entitled to only Rs 1 lakh if your bank goes belly up? The colour of the bank ‘s capital (state-run, foreign, private or urban co-operative bank) is of no consequence. It’s a different matter that the political class may be shielded, and that Mint Road may not let things come to such a pass. For some time now, there has been a clamour that this cover be increased — the last revision was on 1 May 1993 to Rs 1 lakh. And the attendant debate is: should all banks be treated equally? Because all of them don ‘t have the same risk profile — some are good, others bad, and a few, downright poor. Change is under way. A Reserve Bank of India (RBI) committee chaired by Jasbir Singh favours what is known as a “differential premium system” for banks in India. Oh, and by the way, the entity that insures bank deposits is the Deposit Insurance and Credit Guarantee Corporation of India (DICGC), which is an arm of RBI set up in 1962, and Singh was its executive director. What’s the issue here? At its heart is the concept of  ‘moral hazard’. Economist Paul Krugman described it as “any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.” In the context of deposit insurance, you can have a situation wherein insured banks have an incentive to accept more risks, while the depositors loosen their monitoring of risk in the banks they hold the deposits in. And both glibly hold the view that costs emanating from the excess risk will be borne by the insurer or even the exchequer (taxpayer), and that the depository institution will not normally be allowed to fail. <img alt="" src="http://bw-image.s3.amazonaws.com/EFFECTIVE-INSURANCE-lrg.jpg" style="width: 602px; height: 415px;"> The RBI committee, therefore, felt that “a hike in cover without calibrating the premium rates to the risk profile of the insured banks only exacerbates the moral hazard. Recognising this, it has been felt that introduction of RBP (risk-based premium) may be taken up to make ground for considering raising the insurance cover from the present ceiling of Rs 1 lakh.” It’s not an altogether new concept. The Jagdish Capoor Committee on Reforms in Deposit Insurance in India (1999), and the Committee on Credit Risk Model (2006) constituted by DICGC, also recommended introduction of RBP for banks and urban co-operative banks. But it did not see forward movement, as co-operative banks and regional rural banks, which account for over 90 per cent of insured banks to the extent that there are more of these types of deposit-taking entities, were under what many will term “perpetual” restructuring until recently. So too, the absence of a robust supervisory rating for all insured banks, especially co-operative banks. So do you have the right to know the risk profile assigned to the bank where you keep your money? We now step into a delicate area. The Committee says the practice with different deposit insurance agencies is that, at the minimum, a basic rating framework with input variables and their weights is disclosed to the banks at large. “However,” it notes, “a bank’s actual rating is shared with only the bank concerned, the latter being important as a disclosure of rating in public may have negative consequences for a bank such as fears of bank runs if the rating is low on the scale”. It begs the question why do such weak banks even exist. Let’s view the weak-versus-strong-bank argument from the ownership perspective. Are state-run banks to be perceived as relatively less risk-prone? The Committee held that internationally, the preponderant view is that all safety-net tools should apply uniformly across all classes of institutions, and taxpayers’ money should not be used in resolving institutional problems. “In similar vein, implicit guarantees in the form of government ownership should not be given weightage in the risk-profiling of institutions”. The Committee also took note of the fact that, over time, government ownership of state-run banks “may be diluted substantially”. The Committee, therefore, recommended “that in all fairness, the rating system should, as far as possible, be ownership-neutral”. So why should stakeholders, and taxpayers in particular, remain in the dark about the exact risk status of a state-run bank that is weak, when the Committee itself notes that government ownership of these banks “may be diluted substantially”? Isn’t it better to quarantine weaker banks — whatever their hue — through “narrow banking”. Let them raise deposits and invest largely in government securities. (This story was published in BW | Businessworld Issue Dated 02-11-2015)