Deposit Insurance: Pre-Emptive Expediency Against Bank Runs or Propulsion of Moral Hazard? Economic and Political Implications in India

Deposit Insurance: Pre-Emptive Expediency Against Bank Runs or Propulsion of Moral Hazard? Economic and Political Implications in India

Sushma Nayak (Symbiosis International University (Deemed), India), Abhishek Behl (Indian Institute of Technology Bombay, India) and Aastha Behl (Pranveer Singh Institute of Technology, India)
Copyright: © 2019 |Pages: 29
DOI: 10.4018/978-1-5225-7208-4.ch001

Abstract

Deposit insurance is intended for providing security to depositors from the standpoint of averting bank runs. It is crucial for nations to examine their institutional environment, banking structure, and regulatory framework before insuring deposits in the interest of maintaining market discipline. In the case of India, while Deposit Insurance and Credit Guarantee Corporation (DICGC) has been contributing appreciably to the stability of Indian banking system by safeguarding depositors against possible loss of their entitled deposits with insured banks, the system is based on “paybox” mandate and affords limited conditional protection to depositors. Guided by the need for a stronger resolution mechanism, the Indian government introduced the Financial Resolution and Deposit Insurance (FRDI) Bill in August 2017, which had its own share of controversies, conceivably the most confounded provisions being the bail-in clause and omission of explicit declaration of maximum coverage. The economic and political pressures, however, led to the dropping of the Bill in July 2018, thus creating further vacuum in an already underprovided deposit protection.
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Introduction

Banks play a significant role in the process of financial intermediation in an economy. One of the primary functions of banks is to accept deposits ‘payable on demand or at short notice’ thereby constituting ‘liquid liabilities,’ while the other is granting loans ‘non-recallable on demand’ thus constituting ‘illiquid assets.’ In this fashion, banks act as key players with respect to maturity transformation (Allen & Carletti, 2008; Havrylchyk & Verdier, 2018). The divergence in maturity — of deposits and loans — exposes banks to liquidity crisis or the odds of self-fulfilling bank runs, with a probability of all/several depositors attempting to withdraw funds at once (Bryant, 1980; Diamond & Dybvig, 1983; Demirgüç-Kunt & Detragiache, 1997; Ennis & Keister, 2009; Calvo, 2012; Iyer & Puri, 2012; Gertler & Kiyotaki, 2015; Andolfatto, Nosal, & Sultanum, 2017; Dijk, 2017; Mattana & Panetti, 2017; Havrylchyk & Verdier, 2018). Such bank runs are generally a product of ‘herd behavior’ or ‘mob mentality’ or ‘mass hysteria,’ when depositors press on panic button to pull out their deposits due to: an outbreak of news — real or rumor — concerning the banks’ financial health (fiscal irregularities) or a downturn following recessionary economic tendencies (downward spiral) when there are qualms that banks may be unable to meet their obligations to depositors owing to cash crunch.

A question that arises is: Why do banks accept short-term deposits payable on demand that make them susceptible to apparent runs? The answer to this lies in the fact that more often than not, only some depositors aim to withdraw funds during a given period, so it is generally practicable to meet such demands without really having liquid assets backing every deposit. The drawback, however, as mentioned earlier, is the susceptibility of such a system to self-fulfilling panics (Diamond & Dybvig, 1983). If people suppose that a bank will fail, every depositor would, in effect, be desperate to withdraw funds in one fell swoop — and since the bank’s assets are illiquid, attempting to cater for those demands may, in fact, cause the bank to fail. This connotes that even healthy banks are prone to panics and flusters, popularly known as bank runs. In a nutshell, the link among depositors appears as a coordination game with two Nash equilibria: one in which nobody tries to withdraw their deposits because they believe no one else will try to withdraw their deposits, and one in which everybody would try to withdraw their deposits because they believe everyone else will try to withdraw their deposits (Diamond & Dybvig, 1983). Banks faced with bank runs frequently seal the shutters and refuse to permit more than a few withdrawals during a given period, which is known as ‘suspension of convertibility’ (Diamond & Dybvig, 1983; Gorton, 1985; Engineer, 1989; Villamil, 1991; Samartin, 2002; Chen & Hasan, 2008; Bordo & Haubrich, 2010; Diamond, Kashyap, & Rajan, 2017). Suspension of convertibility as a provisional measure to reinstate stability may work in the interests of the concerned bank, but is detrimental to the interests of depositors, who are deprived access to their own funds held with the bank. It further indicates the inefficiency of the banking system to create confidence among depositors concerning a reliable investment climate that can stand the tests of safety and liquidity. In such a scenario, the only possible recourse to avoid bank runs is an assurance that the depositors would get their funds back, even if the bank fails (Martinez Peria & Schmukler, 2001). Can there be one such arrangement?

Key Terms in this Chapter

Blanket Guarantee: An announcement of additional protection to certain deposits and financial instruments by concerned authorities, over and above the security extended by premeditated limited coverage.

Bridge Bank or Bridge Entity: A financial institution set up to provisionally to take over and keep up definite assets, liabilities and procedures of a failed bank as a part of the resolution mechanism.

Self-Fulfilling Prophecy: A customary phrase which implies that people expecting something positive or negative to happen, behave in a way that makes the expectation come true even though it was not supposed to.

Herd Behavior: Behavior exhibited by a vast majority of the population, not guided by their own instinct or intuition, but purely as a reaction/response to other people’s actions and behavioral tendencies. Also, alternatively known as ‘mob mentality’ that results in mass hysteria.

Risk-Based Premium: Premium linked with risk taking ability of banks.

Ex Post Funding: Deposit insurance system that allows funding arrangements to secure deposits after a bank failure or systemic crisis.

Moral Hazard: A phenomenon that guides one party in a transaction to take risks, motivated by the fact that the costs of such actions shall be borne by another party.

Ex Ante Funding: Deposit insurance system that allows funding arrangements to secure deposits before a crisis occurs.

Mandate: Power and influence available with a deposit insurer through a set of official guidelines concerning its roles and obligations.

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