In the earlier article on FRDI (Financial Resolution and deposit insurance) Bill, we discussed about why it is futile to think of deposit insurance in case of ‘Too Big to Fail’ banks. It is also a fact that deposit insurance has been one of the rarely used provisions across the world because of the political sensitivity involved. However, even if one assumes that smaller banks can go to stage of insolvency and this provision of deposit insurance will be exercised, the question arises that can we put investors and depositors in the same risk category or not ?

Policy makers have acknowledged this fact in the earlier draft of  FRDI bill by giving the highest priority to deposit holders whereas shareholders are last in the priority of bill. However, the point of contention is that though deposit insurance has the highest priority but  it is only one lakh more than the shareholder who is last in the order of priority.This implies that on bankruptcy, a depositor of 10 lacs in a bank will get one lac rupee back while investor may have to lose all his bucks. So, a depositor takes 9/10 of the risk taken by the investor whereas he is entitled to a pre-defined reward levels of 5 to 6 per cent per annum against the unlimited rewards an investor can have .By this logic, everyone should be an investor because by taking 1.1 times of the risk of the depositor one can have access to unlimited rewards. Only thing is one has to find a good bank and rather than depositing just invest the money in the bank but can the banks survive without depositors?

Depositors are an important pillar of the financial system and it is very important to maintain the significant difference between the risk taken by the depositor vis-a-vis investor. Also, it should be kept in consideration that depositors and investors have very different reasons to come to bank. The investor knows about the risk he is taking when investing in a bank whereas depositors only want to have a place for saving the money and beating the inflation. Further, depositors do not track the financials of a bank as closely as investors do so if a bank is not doing good the investors will come to know much earlier than the depositors who will become the last casualty. Thus, it is not very rational to put the two categories within such a small difference of risk gap whereas the reward gap is too huge.

It is ,therefore, essential that depositors must be put in a much lower risk category compared to the investors.This can be ensured if deposit insurance is increased multi-fold and by giving the first right of recovery from liquidation of the assets of the bank to deposit holders.By adding such provisions , the faith of depositors will sustain in the banking system and will not tilt towards other illiquid and unproductive asset classes like gold and land. It will also ensure that banks keep on getting access to low cost capital from depositors which helps in credit growth as well as overall growth of the economy.

Image credits: PRSindia