The Reserve Bank of India has approved a shift from the existing flat-rate premium system to a risk-based deposit insurance framework for banks. This could lead to lower premiums for banks with better risk profiles and ultimately create a more resilient financial environment, explains Rachana Baid
l What led to the shift to a risk-based system
THE CENTRAL BOARD of Directors of the Reserve Bank of India (RBI) approved a risk-based deposit insurance framework for banks at its 620th meeting held last month. This shift is designed to incentivise sound risk management practices among banks and could lead to lower premiums for banks with better risk profiles. Since 1962, the Deposit Insurance and Credit Guarantee Corporation (DICGC) has maintained a flat-rate premium. Currently, it charge banks 12 paise per Rs 100 of assessable deposits, regardless of their individual risk profiles.
To appreciate the proposed shift from a flat versus risk-based premium model, it may be a good idea to understand what happens when there is no deposit insurance coverage at all. If there is no deposit insurance, banks, theoretically, would pay the interest rates on deposits that would reflect the inherent risks the deposits carry. Riskier banks will be able to mobilise deposits at a rate higher than others. With deposit insurance coverage, from the point of view of the depositors, the difference between riskier banks and less riskier banks is eliminated and deposits across the board become riskless, at least up to the limit of the insurance coverage.
Under a flat rate of deposit insurance premium, the risk is presumed to be the same. The high-risk banks are subsidised while low-risk banks are penalised, creating a moral hazard problem. The risk-based insurance premium model will address the inherent moral hazard problem.
l Will it enhance overall stability in the banking sector?
THIS NEW FRAMEWORK could enhance financial stability by discouraging excessive risk-taking while maintaining depositor protection. By addressing moral hazard issues inherent in the flat-rate model, the new risk-based system may initially raise costs for smaller, riskier banks, but ultimately aims to create a more resilient and equitable financial environment.
l Criteria to assess insurance premium
SEVERAL METHODOLOGIES FOR calculating the risk-based premium have been documented, including:
n Option-based method: This offers a rational way of pricing the premium, but there are challenges with measuring the asset volatility which is not readily observable in case of banking assets.
n Expected loss method: This methodology is widely used in insurance but may be difficult to fully apply to deposit insurance due to the unique externalities of banksBanks.
n Risk-based bucketing: This is a simplistic process but may lead banks to maximise risk within categories without considering asset quality.
The RBI is yet to release detailed guidelines specifying the exact methodology for the calculation of the risk premium.
l Can this improve the effectiveness of existing risk-based capital standards?
THE RBI MANDATES risk-based capital requirements via the capital to risk-weighted assets ratio (CRAR). Risk-based deposit insurance premiums can complement the risk-based capital standards by providing a direct financial incentive for banks to manage their risk-taking behaviour. Together, these measures will form a stronger regulatory framework that promotes prudent risk management and strengthen the stability of the banking system. This dual approach ensures that banks are held accountable for maintaining required capital levels while also encouraging them to minimise risks in order to reduce insurance costs.
l How this will impact small depositors
AT PRESENT, EACH depositor in a bank is insured up to a maximum of `5 lakh for both principal and interest amount held in the “same right and same capacity”. Under the risk-based deposit insurance arrangement, the insurance coverage will remain the same. However, the framework offers indirect benefits to depositors.
The new framework is aimed to align deposit insurance premiums more closely with the risk profile of individual banks. The linking of insurance pricing to how sound a bank is signals that excessive risk-taking will carry tangible financial consequences where banks with a higher risk profile will bear higher costs of insurance premium while better-quality banks will be rewarded with lower premiums. This alignment is expected to encourage banks to strengthen their balance sheets, improve governance practices, and adopt proactive risk management strategies enhancing public confidence in the banking system.