Digital finance needs to be insured
Why depositor insurance must cover prepaid payment instruments
Trust forms the backbone of our banking system – banks lend to customers after due assessment of the risk they might pose, and customers likewise trust banks enough to hold their money in deposits. Banks have a range of tools and processes to judge a customer’s trustworthiness – from bureau scores and underwriting suites to due diligence measures like KYC.
But information asymmetry is at play here, and it threatens to undermine this covenant of trust on which all banking relies. I wrote in a previous edition of this newsletter:
Unlike banks, customers might not have an armoury of tools to judge the trustworthiness of those providing this service...Borrower trust in lenders is engendered by state-enforced regulation, the trust of equity investors who bet on them in the market, as well as the inherent trust of depositors who trust them with the very earnings and savings leveraging which banks lend.
In other words, a lender is “trusted” if its stakeholders are convinced of a world in which the lender will never make a bad loan.
Customers are not as well-equipped to measure trust in banks as banks are to measure trust in them. And this can be dangerous.
A lack of transparency and financial illiteracy can eventually lead to bank runs -- a phenomenon where customers of bank may rush to withdraw their funds simultaneously over fears of insolvency. India is no stranger to such bank failures.
In 2020, Yes Bank was hauled up by the RBI due to severe stress on its balance sheet due to bad loans and an inability to raise capital for operational business.
Lakshmi Vilas Bank was found to be engaged in irregular lending practices to large corporations and misuse of public fund deposits in 2019.
Punjab and Maharashtra Cooperative Bank had underreported its bad loans despite defaults and was riddled with corporate governance issues.
A prolonged series of bank runs like this challenge the myth of banks’ unimpeachability, and depositors end up paying for their failures by losing their savings or having withdrawals capped.
But they are protected by deposit insurance.
Deposit insurance – a tool of protection from financial loss that might arise from bank failures – is pretty robust in India. The Deposit Insurance and Credit Guarantee Corporation (DICGC) takes care of the “insurance of deposits and guaranteeing of credit facilities and for other matters connected therewith or incidental thereto”. It boasts coverage of the second-largest number of deposit-taking institutions, after the US.
Deposit insurance is mandatory for all banks in India, including foreign banks
The DICGC covered 1,997 banks, including 140 commercial banks and 1,857 cooperative banks
The insurance cover limit is Rs 5 lakh per depositor
On a by-account basis, the coverage ratio in India at 97.9% is in line with the global median
The DICGC Act was amended in 2021 to include up-front payouts within 90 days of the bank being barred from discharging their liabilities
The DICGC’s portfolio is valued at USD 24.5 billion
Indian depositors may seem well-protected under these measures. But there’s a worsening leak in this policy that needs attention.
The digital wild card
In addition to digital payment channels like UPI, the use of prepaid payment instruments (PPI) like wallets, pre-loaded cards, and PoS-based instruments has been on the rise. From 49,392 lakh PPI transactions in FY21, three years later in 2024 this number rose to 78,775 lakh in FY24. In terms of value, PPI settlement systems recorded transactions worth Rs 1,97,695 crore in FY21 and Rs 2,83,048 crore in FY24.
This increase is important in the context of deposit insurance because PPI instruments still largely exist outside its purview.
Prepaid payment instruments are loaded with money from a bank account – money that has been deposited in the account by a customer. In fact, the PPIs used by these customers are also issued by the same bank. The case for depositor insurance for PPIs and other digitally stored value products (DSPs) is strong, but evidence shows that little has been done to protect users of these products.
According to a 2019 study conducted by the International Association of Deposit Insurers (IADI):
Of the 51 jurisdictions from regions identified by the World Bank, DSPs are not considered as deposits in more than three-quarters even though the insurers recognise that member institutions are already offering these products
A little over half of the respondents have formally adopted one of the three approaches prescribed by the IADI for decision-making in the protection of DSPs by deposit insurance
In the context of linking DSPs to compliance with its core principles, most jurisdictions did not mandate regular submission of information to the insurer
No jurisdiction had created a separate fund to cover DSPs
Only six jurisdictions had specific requirements for public awareness activities related to insured or non-insured DSPs
Why it is important to have depositor insurance for PPIs?
The sustained use of PPIs, and the systemic shortcomings in protecting their users, are making it more critical to introduce a framework for insurance of PPIs. Aside from this, such insurance is critical for two areas that have also developed under the digitalisation of financial services.
Financial inclusion
Digital financial services have made vast strides in improving financial inclusion. Service providers have brought payments, credit, and investment to the masses. Unfortunately, it is these very masses that need to protect their funds – irrespective of the instrument in which they are held. In fact, the IADI points out that even though it may not be an explicit mandate of deposit insurers,
“The involvement of deposit insurance in the promotion of financial inclusion, for example the extension of coverage to deposit-like stored value products, should be undertaken with the strong engagement of, and coordination with, supervisory authorities and other financial safety-net participants. In addition, public awareness campaigns should adequately address what types of deposits and money transfer vehicles are covered by deposit insurance and what types are not, in order to minimise potential confusion among small-scale depositors and financial service providers alike.”
Regulation
The RBI has been cracking down on unethical workarounds and lapses spawned by digitalisation of financial services. Over the last few years, it introduced several notifications such as prohibiting the use of credit lines to load PPIs. Other developments like its crackdown on illegal lending apps point towards its growing interest in regulating the sector. From the perspective of upholding the consumer interest, coverage of depositor insurance to DSP and prepaid payment instruments will become mandatory in the future. Banks, and the fintech partners powering these services, would be well-advised to enforce this soon.
Conclusion
In 1913, the economist John Maynard Keynes said of India:
“In a country so dangerous for banking as India, (it) should be conducted on the safest possible principles.”
Protecting users of digital financial products like PPIs won’t be easy – the insurer must first resolve issues with traditional deposit insurance. Despite the DICGC’s vast coverage, 49% of deposits remain uninsured. Moreover, it does not follow a risk-based premium model where high-risk banks must pay higher premiums. Only after these challenges are tackled can we spare resources to insure digital repositories of money.
But progress is underway. The RBI Report of the Committee for Review of Customer Service Standards in RBI Regulated Entities in 2023 recommended that the regulator should examine whether DICGC cover can be extended to bank PPIs and later to non-bank PPIs. Such a development would be a win for regulation, innovation, and inclusion.
That’s all from me for this week. I’d love to know your thoughts!
Cheers!
Rajat