Usha Thorat: Funding of deposit insurance systems
Keynote address by Mrs Usha Thorat, Deputy Governor of the Reserve Bank of India, at the
International Conference organised by the Deposit Insurance and Credit Guarantee
Corporation (DICGC) with the 8th Asia Regional Committee Meeting, Goa, 18 January 2010.
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Ladies and Gentlemen
1. It gives me great pleasure to be in the midst of the deposit insurers of the world. I
have had the pleasure of meeting many of you at conferences in the past and I am delighted
to see you again at Goa - a favourite tourist destination in India, famous for its beaches,
churches and cuisine. I hope you find the time to enjoy what Goa has to offer in addition to
conferring on the very relevant subject of "Funding Deposit Insurance System".
2. The theme of the Conference says it all - funding deposit insurance systems is the
crux of the matter. The global financial crisis has underscored the need for a strong and
stable deposit insurance fund, without which, the credibility of the deposit insurance system
can be eroded; it is also realised that a credible and transparent deposit insurance system is
critical for maintaining public confidence in the banking system and thereby for financial
stability. That the issue of funding is so relevant to the credibility of the deposit insurance
system is highlighted by the unprecedented decision this year by the Iceland Government to
hold a referendum to approve or reject the terms of a state guarantee on the debts of the
Depositors' and Investors' Guarantee Fund, in particular a loan from the governments of the
United Kingdom and the Netherlands to cover deposit insurance obligations in those
countries.
3. It is quite clear that deposit insurance is not designed to deal with systemic crisis of
the proportions that we have witnessed and cannot be expected to be able to deal with a
situation of widespread failure of banks. At the same time, given the contagious nature of
bank failures, it is necessary that the deposit insurance funds factor-in the possibility of
several banks failing simultaneously. In this context, I hope the conference will discuss the
subject of how deposit insurers can determine the adequacy of the deposit insurance fund to
be able to arrive at some agreement on the principles, if not the rules.
Deposit insurance premium
4. While the conventional wisdom has so far been on risk based premium involving
assessment of risk of individual institutions, in the context of what we have experienced in
the crisis, we may have to assess whether the premium based on the assessment of risk of
individual institutions needs to be supplemented by a risk premium based on their
contribution to systemic risk using some measure of size and complexity.
5. An issue that has been widely discussed in the context of the manner of charging
premium for deposit insurance is the mitigation of moral hazard. Core Principles for Deposit
Insurance Systems prescribe that moral hazard should be mitigated by ensuring, inter-alia,
that the deposit insurance system contains appropriate design features. In India, we have not
moved over to risk based premium but moral hazard is sought to be minimised through other
design features, such as placing limits on the amount insured, excluding certain categories of
depositors from coverage etc. The main reason for not moving over to the risk based
premium system is the assessment of trade off between minimising moral hazard and
placing additional burden on banks that are already weak. The banking system covered by
insurance is extremely heterogeneous - ranging from large and strong commercial banks to
small regional rural banks, urban cooperative banks serving local communities and rural
cooperative banks. These banks serve the very important objective of financial inclusion and
meet the requirements of sectors and communities not usually targeted by the larger
commercial banks. Amongst these there are entities that are weak and the sector is in the
process of being strengthened. The stability and soundness of this sector is being enhanced
by weeding out unviable banks through non-disruptive measures. Till majority of these banks
meet the minimum standard prudential norms, we may have to continue with a uniform
premium system which has an element of cross subsidisation. Moral hazard is also sought to
be minimised by operating, through the supervisory mechanism, appropriate disincentives
and penalties where there is discomfort on account of governance and risk management
standards.
6. Some deposit insurers provide for refund of insurance premium when their target
reserve ratios exceed a particular level1. This practice could cut both ways inasmuch as the
insurer may have to resort to collection of extra premium at the time of crisis when the
system is already under strain. Whether some countercyclicality aspects could be introduced
in the premium contribution is something which could also be discussed.
Income from investments
7. The second important source of funding deposit insurance systems is income from
investments. This income will obviously depend upon the size of the funds and the yield on
relatively risk free investments. As such, older systems have an advantage inasmuch as they
have accumulated a sizable level of corpus over a period of time. So far as DICGC is
concerned, investments are permitted only in government securities. A portfolio approach of
tracking a broad All Sovereign Bond Index is followed that which yields a reasonable rate of
return. Only deposits mobilised by branches in India are covered by deposit insurance. In a
systemic crisis situation, where market liquidity for even sovereign securities could be
affected, it may have to be considered whether a collateralised back stop facility from the
central bank could be thought of to enable the deposit insurer to meet immediate needs.
Recoveries
8. The third important source of funding of deposit insurance systems is recoveries
from the assets of the failed banks. Principle 18 of the Core Principles for Effective Deposit
Insurance Systems prescribes that the deposit insurer should share in the proceeds of
recoveries from the estate of a failed bank. In some jurisdictions, deposit insurers have
priority in the recovery over other unsecured creditors including larger depositors. In most
countries the claims are subrogated to all depositors. In cases where the deposit insurer
steps in with sizeable liquidity, there could be case for priority in recovery and in India we
have taken this view where the State law accorded priority to other claims. Perhaps this is an
issue which needs more examination.
Minimising cost of bank resolution
9. Another way in which deposit insurance funds can be conserved is by adopting least
cost solutions for bank resolution. The DICGC has a pay-box mandate under the DICGC Act,
1961. While the appointment of a liquidator or management of assets of the failed banks in
India is not handled by the DICGC, the statute has assigned a role to the Corporation in
resolution of troubled banks, either through a scheme of reconstruction or amalgamation with
another bank. In such cases the Corporation is required to pay to depositors to the extent of
shortfall in the asset coverage, up to the limits prescribed. Of late DICGC in close
coordination with RBI has been using this provision for dealing with the legacy problem of
insolvent cooperative banks rather than the liquidation option in case there are other
cooperative banks or even commercial banks willing to take over such banks. Such solutions
have the potential to serve as least cost option for resolution of troubled banks in the
cooperative sector even within the existing legal framework. The incentive and advantage to
the acquiring bank is transfer of branch licenses and customer base. The realisation of bad
assets in such cases is much better than in cases under liquidation. Moreover, depositors
having deposits more than the insured amount also get back a substantial part of their
deposits. At the same time, payout by the DICGC is substantially reduced. Moral hazard is
sought to be reduced by restricting such solutions to the legacy cases and progressively
bringing cooperative banks on par with commercial banks in terms of minimum prudential
standards and supervisory rigour.
Line of credit
10. In the context of funding deposit insurance, the availability of line of credit from the
Central Bank/Government to overcome temporary liquidity problems in times of crisis is very
important. In several countries deposit insurers heavily rely on such lines of credit. In India
too there is a provision for such accommodation from the Reserve Bank of India. Though this
facility is limited to INR 50 million (equivalent to a little over US dollar 1 million), it has never
been used by the Corporation. A collateralised funding arrangement is something that may
be explored when it is required to deal with situations where markets have become illiquid.
Taxation issues
11. An important issue having a bearing on funding is taxation of income or surpluses
available with the deposit insurance system. Taxation practice varies from country to country.
In Asia region such income/surplus is exempt from tax in most of the countries, but there are
certain countries2, including India, where tax is levied either on the premium income or on
income from investments or the entire surplus of the deposit insurance system. In India, the
entire net surplus of DICGC is subject to taxes. As a result, a major part of the funds
collected by the Corporation by way of premium is paid to the government as taxes. You may
be surprised to learn that DICGC is among the top five taxpayers in the country. Deposit
insurance activity being a welfare activity to protect the interest of small depositors and help
maintaining financial stability, there is a strong case for exempting deposit insurance from
income tax. This will enable the deposit insurer to build up sufficient funds even to meet a
situation of systemic dimensions.
Deposit insurance for financial stability - some current issues
12. The recent financial crisis has highlighted the importance of deposit insurance in
promoting financial stability. The steps taken by governments and deposit insurance systems
all around the world have helped in restoring stability in the system but have also raised the
issue of moral hazard, as aptly summarised by Sebastian Schich3 in his article published in
one of the OECD Journals. Referring to the blanket guarantee extended by the Government
in certain countries he says:
"While these measures did not address the root causes of the lack of confidence,
they were nevertheless helpful in avoiding a further accelerated loss of
confidence, thus buying valuable time. But they are not costless. First, like any
guarantee, deposit insurance coverage gives rise to moral hazard, especially if
the coverage is unlimited. Clearly, in the midst of a crisis, one should not be
overly concerned with moral hazard, as the immediate task is to restore
confidence, and guarantees can be helpful in that respect. Nonetheless, to keep
market discipline operational, it is important to specify when the extra deposit
insurance will end, and this timeline needs to be credible. Second, the
coexistence of different levels of protection could give rise to unfair competitive
advantages; vis-à-vis other forms of savings or vis-à-vis other deposit-taking
institutions that do not enjoy the guarantee. Third, to make a guarantee credible it
is important to specify the manner in which it will be provided......... Looking
ahead, a sharper policy focus will have to be placed on "exit strategies",
especially where unlimited guarantees have been extended. In this context, the
fundamental question remains whether government guarantees can be a one-off
proposition. There may be a general perception that once extended in one crisis,
a government guarantee will always be available during crisis situations."
13. As explained above, in all cases where emergency measures have been taken to
overcome the situation arising out of the financial crisis, it is necessary to have an exit
strategy with a credible timeframe. This is important for Asia Region also, where as many as
five countries4 have temporarily extended blanket guarantee for bank deposits - most of
them up to December 31, 2010. The issue is, however, not only confined to blanket
guarantees but much wider, involving exit from several fiscal and monetary measures as
well, taken earlier on an emergency basis.
14. To conclude, I must say that deposit insurance systems constitute an important
element of the financial safety net having the twin objectives of protecting the interest of
small depositors and promoting financial stability. Adequate funding of deposit insurance
systems is crucial to achieving these objectives. Indeed, the theme of the conference is apt
and the agenda for discussion has been drawn-up very thoughtfully - my compliments to the
organisers and best wishes for success of the Conference.
Thank you.