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Are You Assuming Money in Bank Deposits as Safe? Watch Out!
Aug 7, 2020

Imagine this scenario: You invested Rs 10 lakh in a bank fixed deposit for tenure of 2 years. The interest every quarter for seven quarters was earned/received by you, but just a few months before the deposit was about to mature, the bank owing to multiplying financial troubles (which ultimately led to the banking regulator impose some controls) didn't pay your hard-earned money on the date of maturity.

There are numerous such instances, where investors have lost their hard-earned money with banks ---owing to financial mismanagement at banks --- and consequently, the Reserve Bank of India (RBI) taking Prompt Corrective Action (PCA) against them. Currently, UCO Bank, United Bank of India, Central Bank of India, Indian Overseas Bank, Punjab & Maharashtra Co-operative (PMC) Bank, to name a few are under the PCA of the RBI.

The track record of co-operative banks has been horrific. According to RBI data, there were 1,926 Urban cooperative Banks (UCBs) in 2004; and over the last 16 years, the RBI was compelled to merge 129 weaker cooperatives with stronger banks. Nearly 246 UCBs collapsed over the last 16 years.

And this risk of default is only increasing; the potential risk is systemic and things could get out of hands quite quickly if timely measures aren't taken.

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The latest, i.e. the 21st edition of Financial Stability Report (FSR) released by the RBI, highlights several downside risks, although India's financial system remains stable. All major risk indicators, global risk, financial market risk, and expected macroeconomic risk, remain in the 'high' to 'very high' zone.

RBI has cautioned all stakeholders (which includes depositors as well) about the potential rise in Gross Non-performing Assets (GNPAs) of the sector in the coming quarters.

As the on-going pandemic has affected life as well as livelihood, its impact on credit growth, the asset quality of banks, and the capital adequacy of banks has been and is likely to be adverse. The process of deleveraging of corporate balance sheets, which was making steady progress during the pre-COVID times, got severely impacted by the pandemic.

Macro stress tests for credit risk indicate that the GNPA ratio of all SCBs may increase from 8.5 per cent in March 2020 to 12.5 per cent by March 2021 under the baseline scenario. If the macroeconomic environment worsens further, the ratio may escalate to 14.7 per cent under very severe stress, mentions the RBI's Financial Stability Report.

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According to the FSR, close to 67% of customers of Public Sector Banks (PSBs) and 49% of customers of private sector banks availed the moratorium facility as of April 30, 2020. Nearly 1/3rd of the loan book of private sector banks and 2/3rd of the PSBs was under moratorium.

Isn't this a scary scenario?

Time and again, the government has assured that depositors' money with banks is safe; but please do not take such assurances too seriously.

Given that NPAs of most banks are on a rise, your hard-earned money is not necessarily 100% safe with a bank.

The financial stress in the Indian banking system (and debt market) is certainly building up, and this increase in the systemic level may blow off investors' money for no mistake on their part.

The government introduced the Financial Resolution and Deposit Insurance (FRDI) Bill in the lower house of the Parliament in August 2017 but subsequently withdrew it in August 2018. This is because in the proposal of setting up a resolution corporation, the Bill had an extremely controversial bail-in clause, wherein it effectively permitted conversion of the term deposit with the bank into equity to recapitalize the bank if it fails.

Bail-in is the opposite of bail-out. When a government bails out a bank, it primarily uses taxpayers' money to save that entity. In contrast, the bail-in clause permits using depositors' money to reduce the liability of the bank. Given the strong uproar in the media, the government had to back off on the proposal.

Just before the COVID-19 pandemic hit the country in March, the government was pondering upon introducing the modified version of FRDI, rechristening it as Financial Sector Development and Regulation (FSDR) Bill.

And now that the banking and financial sector has come under massive pressure amidst the coronavirus pandemic, the talks of setting up a resolution under the legislative framework of the new FSDR system has started gathering momentum. Non-Banking Financial Companies (NBFCs), insurance companies, capital market players, co-operative societies, regional rural banks, payment banks, will all come under the purview of the proposed resolution authority.

"We need a structured mechanism with the legal backing to deal with stressed assets" opined RBI Governor, Mr Shaktikanta Das.

Under the new system, each regulator will be expected to create a Prompt Corrective Action (PCA) framework for the areas they control. Moreover, some regulatory powers that are at present with the respective financial market regulators could be transferred to the proposed Resolution Authority (RA).

The RA will be self-sustaining and have three funds: i) Resolution Authority Insurance Fund (which will replace the Deposit Insurance and Credit Guarantee Fund); ii) Resolution Authority Fund (covering resolution fees); and Resolution Authority General Fund (for meeting administration expenses).

In the new avatar, although the new FSDR Bill does not have any mention of the bail-in clause, keep in mind that it may still confer the powers of cancelling the liabilities of the failing financial entity or modify the payment terms.

To protect depositors, the government recently hiked the limit of Deposit Insurance Scheme to Rs 5 lakh from Rs 1 lakh earlier, in the Union Budget 2020. If the new bill goes through and the financial sector resolution corporation is established, your deposits upto Rs 5 lakh would mostly be protected.

However, any claim above the present DICG limit, may either involve a haircut or as a depositor you could even be allotted the equity shares as a swap for their deposits in excess of Rs 5 lakh per failing bank.

What investors should do?

Do not take investing in bank fixed deposits (also parking money in a bank savings account) very lightly. In the ongoing COVID-19 crisis, the systemic credit risk is amplifying and it, in turn, would have a bearing on the assets of the bank. Besides, frauds at banks, too, are on the rise.

Hence, when you invest in bank fixed deposits and park money in saving accounts, do all the necessary due diligence.

Broadly, here's what you should evaluate:

  • Whether the bank is a public sector entity, private sector or a co-operative
  • The management of the bank - whether there is political influence
  • The systems and risk management processes in place
  • The financial health of the bank

These aspects are of prime significance for the safety of your hard-earned money.

In the case of Public Sector Bank, since the government is the major stakeholder, usually the chances of default are far less. No government at the helm would run away from its responsibility to its debtors- i.e. depositors. Hence, as a depositor, you would be relatively better off with a Public Sector Bank.

If a private sector bank is providing extraordinary and efficient service but the financial health of the bank is poor, it would be prudent to steer away from such a bank in the interest of your financial wellbeing. Likewise, not ruling out the odds of financial irregularities, also be ultra-careful when you park hard-earned money with co-operative banks.

To make sure your money remains safe, deal with only with strong-well-capitalised banks, with low NPAs, and respectable capital adequacy and a provision coverage ratio. Opt for banks with reasonably clean balance sheets.

And ideally, diversify across 3-4 banks and avoid having an exposure over Rs 5 lakh to any individual bank.

If you follow certain safety guidelines to you park hard-earned money with a bank, there is nothing to fear and you will be able to sail through the growing uncertainty in the Indian banking sector.

PS: If you wish to invest in a readymade portfolio of top recommended equity mutual funds based on the 'Core & Satellite' approach to investing, I recommend that you subscribe to PersonalFN's Premium Report, "The Strategic Funds Portfolio For 2025 (2020 Edition)". This premium report will help you build your optimum mutual funds portfolio for 2025 without any effort on your part. If you haven't subscribed yet, do it now!

Happy Investing!

Author: Rounaq Neroy

This article first appeared on PersonalFN here.

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PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.


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