Small depositors
THE State Bank of Pakistan (SBP) has recently doubled the guaranteed amount from Rs250,000 to Rs500,000 per eligible depositor per bank. As the vast majority of depositors are small, typically uninformed and unsophisticated, it is vital to comprehend what this protection entails.
A brief background is in order. SBP established the Deposit Protection Corporation (DPC) in 2018, guaranteeing small deposits in case a bank goes bust. Yet the idea of a formal, ex-ante and explicit deposit protection mechanism, contrary to an arbitrary arrangement cobbled together post a bank failure, is hardly novel. The Federal Deposit Insurance Corporation in the US was the first such agency, set up in 1933 to shore up waning public confidence amid rampant bank failures. Similar schemes are now in place in 146 countries.
Establishing a DPC in Pakistan has been a step in the right direction. First, it has proffered a pre-defined mechanism to protect depositors of all banks — public or private, Islamic or conventional, large or small, local or foreign — levelling the playing field somewhat, even if the public perception of some large banks as ‘too big to fail’ may persist.
Prior to DPC, depositors of private banks were virtually under no formal coverage. Though the government had fully guaranteed deposits of all banks under the Banks (Nationalisation) Act of 1974, the privatisation drive from 1990s onwards led to a concomitant drop in the share of public-sector banks. By 2018, over 80 per cent of the banking system was in the private sector, thus uncovered by the Act. DPC has filled that critical gap.
Establishing a DPC has been a step in the right direction.
Second, instead of offering a blanket guarantee, DPC aims to protect only small depositors — rightly so. Fully covering all, especially large depositors is neither prudentially desirable (as it exacerbates moral hazard) nor financially viable (as it requires colossal funding).
With the recent jump in coverage from quarter to half a million rupees, SBP reported that up to 95pc of all eligible depositors (essentially all types of retail, sole proprietorship and partnership deposits etc) are now fully guaranteed. This amounts to a fairly high degree of coverage, even if the value of coverage, at roughly 2.5 times of our current GDP per capita, is still half of the average for low-income countries. However, the coverage level fares better if viewed against the 80:20 rule of thumb which suggests covering 80pc of all depositors and 20pc of total value. In any case, the full protection of 95pc eligible depositors should significantly mitigate the risk of a bank run, an otherwise natural reaction of uninformed depositors to any rumour of bank failure.
Equally relevant is to note who is uncovered by DPC, whether in part or entirely. This respectively boils down to two categories; first, a fraction (5pc) of eligible depositors with total balance per bank above 0.5 million are only covered up to that amount with the rest uncovered, and second, a group which is ineligible for any coverage at all (primarily government, corporates, and insiders’ deposits). Both these exclusions are a part of global best practices. While the case for the latter is obvious, fractional coverage of large depositors is warranted as they arguably have the incentive, capacity, and sophistication to closely monitor their banks’ performance and can penalise riskier banks by the timely moving of their funds elsewhere; this helps reduce moral hazard and bolsters market discipline. Failure to exert such pressure could leave big depositors wading through protracted court proceedings for recovery of their uncovered deposits when a bank goes under. Whether DPC has truly nudged big depositors to keep a close eye on their banks’ performance is however a moot point.
Third, by charging banks an insurance premium for deposit protection, currently at a flat rate, DPC is making banks foot the bill, not the depositors or the government. This should considerably limit, if not entirely remove, the need for use of public funds to bail out private banks in future. At some point, DPC should also switch over from fixed to risk-based premiums, demanding riskier banks to cough up more.
Finally, a caveat that deposit protection schemes are no panacea for regulatory shortcomings. While these mechanisms can forestall bank runs or facilitate orderly closure of a failed bank by ring fencing the savings of small depositors, a robust supervisory regime that continues to ensure a sound banking system would remain a precondition. Moreover, such a scheme can only manage individual, occasional bank failures; handling a systemic banking crisis would fall beyond its scope and resource envelope, inevitably requiring the government to step in.
In some sense, DPC is akin to a firefighting system; critical to have but one you wish you never reach a point of using.
The writer has served as an adviser to the governor, Central Bank of Kuwait.
Published in Dawn, October 3rd, 2021