How can a bank fail? In simple words, a bank is said to be failed when it cannot give back the depositor's money as and when demanded. How can this happen? This can happen when there is not sufficient liquidity with the banks. That can happen when they have lent out all the capital money and also the depositor's money on long term loans and also when the owner's capital as well as depositors money is diverted to other banking un-related purposes. This used to happen in early days when many private and proprietary banks were in operation. Even the owners used to run away after collecting depositor's money. (This happens here and there even now, but not as banks but as non-banking enterprises or individual activities)
Many such private banks failed and depositors lost their money.
That was when banks were nationalised in India. From then on the nationalised banks were owned by the Central Government and they had the backing of the government. In order to make credit available to the common man and masses, nationalised banks were directed to lend to priority sections at low interest rates. Banks were also directed to open new banks only in rural areas. Due to political propaganda there was a mistaken feeling among the borrowers that such loans need not be repaid. Most nationalised banks were to content with huge number of such bad loans.
The government being the owner pumped more money to save the banks.
In the next phase, the economy was 'opened up' and new generation private banks were also opened.
While nationalized banks were subjected to lot of statutory restrictions, the new private banks relative enjoyed more freedom. Gradually nationalised banks were also allowed o have private shareholding to a certain percentage.
However, devoid of any social commitments private banks were aiming huge profit to show to their shareholders. In that process they lend to big business houses, and to business houses in some way related to the directors of the bank itself. Some banks failed.
At the same time nationalised banks were compared with private banks in performance and they were also tempted to lend big ticket loans under various compulsion. Many such loans did not come back and these banks were burdened with huge NPAs. However the government had to save them as they are owned by government.
As of now, there are capital norms and various statutory restrictions or banks and there are mechanisms and legal avenues for NPA recovery. So bank failure may not be so easy, if the regulatory controls are well exercised and no deliberate mala fide actions are done.
However, in case a bank fails, under the Deposit insurance facility a depositor is insured to a maximum of Rs 5,00,000/- . Moreover just as a company is liquidated, there will be such processes in evaluating the assets and liabilities and accordingly the depositors may get their proportionate amount as per the final settlement.
But practically, the government will not allow this, because bank failure can have detrimental effect in the image and rating of the economy. So the RBI and Central Government will step in and do some remedial measure. That may be time consuming too.
Generally, there will be some warning signals emanating from such instances. The regulator (RBI/Government) will immediately put in restrictions like stopping further lending or restrictions certain operations. The bank is given some Corrective directions to come back healthy. If that fails, there will be moratorium also. The depositors will be allowed to withdraw only limited amounts.
The present Central Government (mainly due to international pressure) is planning certain amendments in banking regulations. It may not be good news to depositors. They are planning to make rules that when a bank is facing crisis, the deposits may be used to tide over the problem and the deposits will be treated as long term liabilities only. It is only as a prior soap that the DICGC insurance cover for deposit is increased to Rs5,00,000/-.
Presently due to the strong objection of bank unions on behalf of depositors this unfavourable amendments are held for the time being.
In fact government and economist are now encouraging to borrow and spend. Savings is discouraged and borrowing is encouraged by decreasing the interest on both.
Prudent says that you may keep your deposits segregated in different names (of your family members) and in different banks. As the saying goes, 'Do not keep all your eggs in one basket".