Why your FD strategy needs a rethink

Ever since we started our coverage of FD products at PrimeInvestor, we’ve taken a very conservative approach to the entities whose deposits we recommend. Always putting capital safety over rates, our recommended list of FDs has been made up mainly of post office schemes, systemically important banks and very select NBFCs.

There are two reasons for this play-it-extremely-safe approach. One, unlike equities, where the upside from taking risk can be unlimited, in deposit products the extra return for risking your principal is limited. Two, though bank depositors in India are protected by deposit insurance up to Rs 5 lakh in the event of bank failure, getting your hands on that insurance money is not a certainty and can take many years.  But last week, the Deposit Insurance and Credit Guarantee Corporation (Amendment) Bill 2021 was passed by both houses of the Parliament. This Bill intends to improve the way bank deposit insurance works in India. Here’s how this amendment affects you and changes our approach to recommending FDs.

How it works today

Today, every depositor in a co-operative or commercial bank in India is eligible to get an insurance payout of up to Rs 5 lakh towards his or her savings, term, recurring and current account balances (principal plus interest) in the event the bank is wound up. This insurance payout kicks in when a bank is liquidated after RBI passes an order cancelling the bank’s license to operate. 

But there can be quite a long time gap between RBI restricting deposit withdrawals from a bank and its eventual liquidation.   

Usually, when RBI is concerned about a bank’s finances or its management, it loses no time in imposing ‘directions’ on the bank under section 35A of the Banking Regulations Act. Such ‘directions’ can stop the bank from undertaking any new fund-raising, lending or deposit activities. They also set a hard limit on the total amount that every depositor is allowed to withdraw from the bank. This withdrawal cap has varied from Rs 1,000- Rs 50,000 per depositor in the past. RBI usually gives no prior notice of its ‘directions’, because its main intent is to prevent a run on the bank. 

Though intended to save the bank, such directions tend to put depositors in limbo, with no access to their money. A lot of time can elapse between RBI placing a bank under ‘directions’ and the bank’s eventual liquidation, which is when DICGC begins processing insurance claims. Even after DICGC begins the process, the liquidator may take their own time to compile depositor details, prolonging the process. 

Data from the DICGC annual reports tells us that in FY20, depositors got their claims after 508 days on an average. In FY19 the delay was 1425 days and in FY18 it was 2075 days. The amount of claims paid out by DICGC are also pretty small, with only Rs 296 crore ever paid out against the 27 commercial banks that failed and Rs 4903 crore paid against 357 co-operative banks that failed.

What the new Bill does

The new, just-passed Bill makes three changes to the way deposit insurance works.  

1. DICGC will now become liable to pay bank depositors their actual deposit amount or the insurance amount of Rs 5 lakh whichever is lower, as soon as RBI places a bank under ‘directions’ or deposit withdrawals are restricted in any way. This will mean that depositors acquire a legal claim on DICGC as soon as they lose access to their money. They won’t need to wait for the bank’s license to be cancelled. DICGC will be processing their claims parallelly even as authorities work out ways to bail out, rescue, merge or liquidate the bank. 
2. Within 45 days of such an order, the bank has to furnish a full list of its depositors and their claims to DICGC. Within 30 days of receiving this list, DICGC has to verify the depositor details online. Within 15 days after this, it has to finish paying out the depositor’s money into their chosen accounts. Overall, the total time taken by DICGC to settle depositor claims cannot exceed 90 days from the time withdrawals are restricted. If RBI lifts its deposit restrictions within 90 days and the bank is able to repay depositors, then DICGC’s liability ceases. In the case of banks where RBI directions or deposit withdrawal limits are already in force when this Bill becomes law, DICGC will need to pay out claims within 90 days of this Act taking effect. Depositors in dozens of co-operative banks currently under RBI moratorium can look forward to quick settlement, once this Bill becomes law.
3. Where RBI is working on a scheme of merger, arrangement or restructuring of the troubled bank, it can ask the DICGC to further extend the time taken by it to pay out deposit claims by another 90 days. In such cases, depositors may need to wait for 180 days (6 months) instead of 90 days to get their insurance money. 

The troubled bank, on liquidation or merger, is expected to pay DICGC whatever it realizes from its assets within the timelines set by DICGC.

Who pays?

So, who’ll be paying the additional cost for these changes? You can rest easy that it is not going to be the depositor. 

Under the DICGC Act, all banks covered by deposit insurance are liable to pay the DICGC an annual insurance premium which is calculated as proportion of their deposit base. All scheduled commercial banks and foreign banks, State, Central and Urban co-operative banks and regional rural banks thus pay an annual premium to DICGC. 

Currently, this premium is fixed at 12 paise for every Rs 100 in deposits held by a bank. But the new Bill allows DICGC to fix premiums for different banks as it likes, subject to a cap of 15 paise per Rs 100. It is likely that the DICGC will bring in differential premium rates for co-operative and commercial banks because the former are subject to more frequent failures.  Banks will need to pay premiums out of their incomes.

How does it change things?

The amendments to the DICGC Act, once they take effect, will mean the following for your own FD strategy.

• If you’re thinking of parking your surplus with a commercial bank or co-operative bank with weak financials for higher rates, this has become a less risky proposition than before. Earlier, if RBI imposed withdrawal restrictions, you never knew when you would get the insurance money. Now, you can be fairly sure that you will get it back within 3 months or 6 months at the most. With the DICGC, which is an RBI subsidiary, legally bound to pay you the insurance money within this timeline, there’s greater certainty of payout.  
• If you are weighing deposits in a co-operative bank versus a commercial bank, after this amendment there will be no difference in the working of insurance between the two. Earlier, commercial banks were preferred because they were usually quickly rescued by RBI while co-operative bank depositors were made to wait indefinitely. After this Act comes into effect, DICGC will be liable to pay the insurance amount to depositors in co-operative banks also within 3 months, or 6 months at the most. However, given the high rates of failure in co-operative banks you should consider them over commercial banks, only if you are prepared to lose access to your money for 3 to 6 months.  
• Small finance banks (SFBs), which are riskier than commercial banks, usually pay higher rates on their savings as well deposit accounts. They become more attractive after this change. As SFBs are far more tightly regulated and better managed than co-operative banks, you should consider them ahead of co-operative banks for deposits. 
• As only banks and not NBFCs are covered by deposit insurance, bank deposits, irrespective of whether they are with co-operative banks, commercial banks or SFBs now become a safer option than NBFC deposits. Top-tier NBFCs will be worth considering only if they pay premium rates over and above private banks and SFBs. 
• Given that the insurance payout is subject to a Rs 5 lakh limit per bank per depositor (this includes all kinds of accounts, and principal plus interest), you should restrict your deposits in SFBs or riskier private banks to Rs 5 lakh. 
• If choosing riskier banks, it remains a good strategy to diversify your deposits across multiple private banks or SFBs, because even if one bank lands in trouble, another can still provide liquidity.  
• For your emergency fund, systemically important banks that face negligible risks of RBI directions would still be your best bet. Insurance or no insurance, the main feature you should look for in an emergency fund is all-time access and anytime liquidity. There is no point in taking risks with a 3 or 6-month moratorium, with your emergency money.  

We will be making changes to our FD recommendations shortly based on the above. Watch out for our alert on this.