Deposit Insurance and Banking Stability

Source-This post on Deposit Insurance and Banking Stability has been created based on the article “Zero bank failure is the best deposit insurance” published in “LiveMint” on 22 August 2024.

UPSC Syllabus-GS Paper-3- Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development and Employment

Context- The article highlights the decreasing popularity of bank deposits and highlights the importance of deposit insurance in preserving trust in the banking system. With banks struggling to attract deposits, the finance minister and RBI Governor have urged increased efforts to boost deposit mobilization. Since banks keep only a small portion of deposits and lend out the rest, maintaining depositor trust is important to prevent bank runs and potential collapses.

What are the reasons behind decline in bank deposits in India?

Read More- The Deposit Crunch in Indian Banking

What is the Importance of deposit insurance?

In India, deposit insurance is managed by the Deposit Insurance and Credit Guarantee Corporation (DICGC). As of March 31, 2024, 97.8% of all deposit accounts were fully insured

1) Protection for Depositors- It is a vital safety net that protects individuals’ money if a bank fails. In India, it covers up to ₹5 lakh per depositor, giving account holders peace of mind that their savings are secure.

2) Macroeconomic Confidence– It is important for maintaining trust in the banking system. It reassures depositors that their money is safe, which helps banks function effectively and lend to various sectors. This support is essential for economic stability and growth.

3) Risks Amplified by Technology- The rise of digital financial services and social media has heightened the risk of bank runs, as panic spreads quickly online, causing rapid withdrawals. Recent bank failures in the US and Europe in 2023, driven by poor liquidity and flawed business models, underscore the urgent need for strong deposit insurance.

What are the challenges in insuring deposits?

1) Regulators face challenges in deciding whether to provide full deposit insurance, address moral hazard concerns, and whether to offer extra coverage to specific groups like senior citizens and small depositors.

2) A major challenge in deposit insurance is matching insurance costs to each bank’s risk level. This helps prevent risky behavior and keeps insurance premiums fair.

3) Digital banking adds new challenges, like how to insure digital deposit products and manage risks such as climate change affecting credit quality and borrower repayment.

Question for practice

Why is deposit insurance important, and what challenges are associated with providing it?