Management of Deposit Insurance Fund : Indian Experience

1. Management of Deposit Insurance Fund : Indian Experience

2. Presentation Outline • About DICGC Funds • Adequacy • Management • Governance • Taxation • Conclusion Indian Experience

3. About The Oldest Pay Box in the World Snapshot - As on 30 September 2009 INR Billion U$D Billion U$D 1= INR 47

4. About DI Fund Features Three Balance Sheets A Single DI Fund – Advance funded @ Flat Rate Covers liquidation, amalgamations, reconstructions, compromise schemes Explicit back-stop for DIF is insignificant Actuarially determined liability sequestered as a part of DIF No dividend pay-out / operating expenditure charges In case of liquidation of DICGC – DIF Assets: To insured banks in proportion of premium paid Other Assets: To Reserve Bank of India

5. About DIF - Source and Application Fund Back up from RBI (India’s Central Bank) pegged at originally fixed INR 50 Million as against currently achieved DIF of INR 175.65 Billion.

6. About DIF – Contributors to Gross Revenue INR Billion

7. About DIF – Disposal of Gross Revenue Consolidated for 10 years period 1999-00 to 2008-09 (in INR Billions) ToNet Income Tax To Investment Depreciations

8. About Pay Box Trident on Fund Assessment Deposits understated ? Tackled INR Billion Direct and Indirect Tools  DI Fund Since 1962 Is recovery and its sharing with DICGC just ? Claims submitted by liquidators not overstated ? Being Tackled Tackled Comm. Coop All 41 % 8 % 11 %

9. Fund Adequacy Relevance of Reserve Ratio No Hard / Soft Target Reserve Ratio Prescribed Numerator Bias Free Surpluses are the major component The capital not counted – available in case of need. Actuarial Liability counted as part of Reserve Denominator Bias Insured Deposit Ratio : Back Testing for Coop Banks Estimation Error – Depositor-wise Aggregation Reporting Error –Coverage & quality of reporting Time Lag –Insurable Deposit Vs. Insured Deposit ‘Going Concern’ prejudice – Back Testing Results % Standard Deviation of 12.41

10. Fund Adequacy Actuarial Liability - DIF Actuarial Liability = PV of Claim Outflows - PV of Earnings Inflows Broad Assumptions Claims restricted to the current insured deposits till projected maturity. Year-end deposits go down by 20% each year cumulatively on reducing balance basis. The ratio of Insured deposits to insurable deposits is basis for projections fund flows. Premium, Interest and Tax rates are the current rates. Claim Rates based on historical bank mortality married with forward looking supervisory indicators. Margin of adverse variation in rates and margin for adverse claim ratio are factored in. (INR Billions) Actuarial Fund Back Testing

11. Fund Adequacy Fund / Reserve Ratio Fund Ratio (Percent) Fund Size (INR billion)

12. Fund Adequacy Category-wise Loss Distribution Too Big To Save ? Residual ‘tail’ risk well-covered Historical Mortality Risk

13. Fund Adequacy Deposits Demography Fund Viability CAGR 19.11 % Deposits Growth

14. Fund Adequacy Multi-factor Stress Testing A Member of Financial Stability Unit (FSU) set up by RBI Increased Cover Increased Bank Failures Deposit Insurance Fund Tax Exemption Premium Hike Recapitalization by RBI

15. Fund Adequacy Recent Topical Initiatives Increase in Premium Move to Risk Sensitive Premium (2008) Making Actuarial Evaluation more forward looking (2009) DICGC assisted merger policy for legacy weak coop banks (2009) RBI panel recommendation for Emergency Fund Facility for Urban Coops under Industry Support Agreement (ISA) for short & medium term (2009) - contributing interest-bearing 0.05 % of assets to a Fund (not DICGC)

16. Fund Management Risk Management Framework Liability and Assets Perspective of DICGC Risk Identification and Measurement Current Risk and Investment Policy Risk Management Framework - Review Liability Driven Investments (LDI) Interest Rate Risk Management Choice of Planning Period Cash Flow Matching & Investment Categorization Surplus maximization & Return Management Policy of Rebalancing

17. Fund Management Investment Policy Structure Purpose / Scope of Policy Investment Objectives Investment Processes Investment Accounting / Valuation Reporting and Reviewing Authorized Investments Investment Committee Delegation of Authority Standard of Prudence Portfolio Strategies Counterparties Dealing through Brokers ONLY CENTRAL GOVT SECURITIES

18. Fund Management Investment Approach Within Acceptable level of Risk No Target Returns Meeting liabilities within defined planning period. An ALM / Structural Liquidity Approach Strategies Tool Kits Benchmarks Reviews B. Maintenance of orderly cash flow A. Managing Deposit Insurance Fund C. Maximization of Returns Principal Protection ? Viability of Fund established ?

19. Fund Management Tools & Benchmarking Portfolio approach - tracking of an ‘All Sovereign Bond Index’ Duration ± Leeway Targeting ‘Tracking Error’ monitored Virtual tranching of portfolio in to ‘core’ & ‘current’ dynamically. ‘Market Risk’ - Higher of ‘Standardized Duration Method’ and ‘VaR Method’ Time Weighted Return (TWR) Close watch on portfolio Duration and corresponding re-balancing Main Constraints Single asset class held on fully-invested basis Few money market instrument permissible Both cash flow liquidity and market liquidity Well-nigh absence of back –up funding facility

20. Fund Management Total Returns Route % All Index of Clearing Corporation of India (CCIL)

21. Fund Governance Transparency & Disclosures Expressly precluded from taking speculative position Day-to-day audit of treasury transactions and procedures by external concurrent auditors Daily Performance Dash Board before the CEO Monthly Review by Investment Committee Quarterly structured review by Audit Committee and Board Annual Statutory Audit by independent auditors and certification Face / Book / Market Value of investments disclosed on-balance sheet Significant Accounting Policy disclosure as per Indian GAAP Disclosures about Repo / Reverse Repo transactions Trades on Order Matching System and settlement through CCP. Direct member of RTGS

22. Fund Governance Potential Impact of IFRS on Fund Size Industry Specific Guidance may need to evolve at country level Change in value between trade and settlement day to be recognized Appropriate classification of Investments Fair Value Measurements Realized / Unrealized losses / gains in investments Inventory accounting method may change taxable income Transaction Costs Accounting Threshold of Contingent Liabilities Consolidation of Funds under control Risk Management Disclosure Risk Reporting

23. Fund Governance Investment Value Buffer INR Billions INR Billions

24. Fund Governance Jury is Out Active or Passive Management ? Trading Portfolio ? Asset Class Diversification ? More risk management instruments ? Best method for credit lines / back-stops ? Governance Angle – Arms length from the Central Bank Legal Authority for New products / avenues

25. Taxation Canons of Taxation on Fund • Exempt from Income Tax between 1962 and 1987 (25 years) • Now, Among top 10 Corporate Tax Payers in India • Taxed like any mercantile company - no special status for premiums • Demand of Service Tax on par with non-life insurance diffused • Substantial amounts locked up in dispute with Tax Authorities • Premium being tax deductible in the insured bank’s hands, cost impact is less in case of profit making banks compared to loss making banks • Fund build-up during non-crisis time thwarted by higher tax liabilities • Pay Box mandate compounds inability for tax planning

26. Taxation Fund build-up in non-crisis time INR Billions Premium @ 0.05 % 0.10%

27. Conclusions (1/2) Changed financial systems dynamics -revisit of the public policy objectives and mandate for effective DI funding in India. Weak recoveries with category-wise, region-wise skewedness do not align with core principles and is a major bane to fund recycling. Reserve Ratio : A necessary but not sufficient measure of DIF adequacy. Both numerator and denominator warrant more country-specific ‘culturing’. Inadequacy Mitigation - Favourable Credit Deposit (CD) Ratio , good Capital Adequacy, High Provision Coverage Ratio (PCR) etc. In Indian banking system Litmus Tests -Fund survival of failure of the insured bank with largest liability ; severe scenario of failures, short of systemic failure of the banking system. Framework for India specific denominator option based on loss distribution is still in search of a model in view of heterogeneity in Indian Banking.

28. Conclusions (2/2) The banking consolidation buzz should reckon de-‘tailed’ ’ loss distribution for DIF. Fund Management still treated as a non-core DI function. Deposit Insurer’s investments need evolution as a body of specialized knowledge. Market Risk to DIF is a major concern. Optimizing Holding Period Return after addressing the claim liabilities may be way to go regardless of accounting results. Co-ordination of pay-box with bank supervisors key to LDI and better tax management. Categorization of investments should be tax efficient . With absolute ‘mutuality’ / ‘Industry Capital ‘ nature of DIF, tax-exempted premium should be logical choice. A pay-box should not be treated as a ‘low hanging fruit’.

29. Comments or Questions, Please Thank You for your valued attention Email: jkdash@rbi.org.in www.dicgc.org.in