Banks need depositors’ loyalty. Only with a stable, predictable deposit base can banks confidently make loans and keep the wheels of finance turning.
Regulators do their part to make sure banks are worthy of that trust. At times, this can mean levying uncharacteristically large penalties, such as the ones that India’s regulatory agency imposed on a handful of commercial banks in 2013. Do such actions give depositors more faith in the financial system? Or do they shake customer confidence and cause them to pull their deposits from all banks?
The answer is the latter, at least when trust in public institutions is already low, as it usually is in developing countries, according to Abhiman Das of the Indian Institute of Management Ahmedabad, Tanmoy Majilla of Plaksha University, and Chicago Booth’s Rimmy E. Tomy. The researchers argue that trust is crucial to the effects of penalties, as it points to whether depositors see a regulator as having correctly identified a problem or as being the source of larger systemic issues.
The researchers took advantage of a unique regulatory event in India in 2013 following an investigation into three major private-sector banks—Axis Bank, HDFC Bank, and ICICI bank—by the news website Cobrapost. The outlet published videos of top bank executives instructing an undercover journalist on money laundering. The ensuing public uproar prompted the Reserve Bank of India to investigate all commercial banks. Although enforcement actions against commercial banks in India are infrequent, the RBI eventually imposed significant penalties on dozens of banks that were found to be in violation of rules.
To see the effect this had on the financial system, the researchers sourced branch-level deposit and credit information from the RBI’s Basic Statistical Returns database, as well as data on monetary penalties issued by the RBI against individuals and banks from watchoutinvestors.com. They also obtained data on demographics, geographic characteristics, and trust.
To delineate the role of trust in institutions, the researchers focused on the deposits of nearby unpenalized banks. Depositors located near offending banks’ branches would likely have known about the penalties—through word of mouth, neighborhood social networks, or neighbors’ actions. If they had reallocated capital within the banking system, they would have likely moved funds to another bank branch nearby. On the other hand, if depositors had removed their funds from the system altogether, the neighboring branches should have also seen deposits fall, the researchers conjectured.
The researchers were able to tie the penalties to deposit behavior thanks to the quasi-random nature of bank-branch locations in India, where openings are driven not just by economic conditions but also by the policy goal of financial inclusion.
A lighter touch from regulators—in coordination with an early-warning accounting system going into effect in December 2019—could deliver fewer shocks to the economy.
Can Smarter Accounting Improve Bank Regulation?After the banks were penalized, customers withdrew their cash from those institutions in a way that was consistent with the researchers’ hypothesis, according to the study. Deposits in sanctioned banks declined by 10–11 percent in the year after the event relative to banks that did not incur penalties.
Customers didn’t move their funds from private to public banks that had an implicit state guarantee—perhaps because just a little more than half of the penalty amount was imposed on public-sector banks, the study notes. Some deposits went to small regional banks where officers, who tend to be from the local community and speak the local language, may have been perceived as more trustworthy. The vast majority of withdrawn cash, however, apparently left the banking system completely.
It is likely that insured and uninsured depositors at the punished banks behaved similarly, the researchers write. Their study could not distinguish between the two types of deposits, but Indian deposit insurance is of limited help for many consumers, explain Das, Majilla, and Tomy. In the United States, checking, savings, and money-market accounts are insured for up to $250,000 per insured account. In India, by contrast, the deposit insurance limit was a relatively low 100,000 rupees ($1,210) for the sample period, 2000–14. Moreover, there were (and still are) significant frictions and delays in accessing deposit insurance in the event that a bank is in trouble.
Utilizing survey data tracking trust in several public institutions, the researchers find that deposit withdrawals were more pronounced in states with a lower level of trust in banks and courts. Trust was closely associated with access to news and information, and the quality of local services such as hospitals and governments, they further find.
Finally, deposits withdrawals were associated with a decline in credit. Using nighttime light intensity as a measure of economic activity, Das, Majilla, and Tomy observed that deposit withdrawals had negative economic effects, which they argue underscores the importance of banks as conduits for local economic growth.
Bank regulators in developing countries, when explaining their supervisory actions, often cite international best practices—but they need to consider that depositors’ preexisting trust in public institutions tends to be lower in developing markets, the research suggests. Several previous studies, mainly conducted in developed markets, suggest that supervisory transparency leads people to move money out of offending banks. (For more on one of those studies, read “Banking regulators operate differently under public scrutiny.”) However, market discipline presumes a certain degree of trust that the underlying public institutions are competent, free of vested interests, and able to enforce laws effectively. Low trust makes it harder to wield market discipline as a policy instrument.
Abhiman Das, Tanmoy Majilla, and Rimmy E. Tomy, “Banking on Trust: Supervisory Transparency and Depositors’ Actions,” Working paper, May 2024.
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