Will savings rate deregulation help banks? Business Standard 9th November 2011

Debate page

Free pricing helps banks manage their costs more efficiently because they can fine-tune them depending on their requirements

Deregulation of interest rates on savings deposits is probably the last mile in interest rate reforms in India. Though the timing may be debated, banks will surely see something good in this move. For the system as a whole these deposits constitute a little less than a quarter of overall funds — they have increased from around 21 per cent in FY00 to 25 per cent in FY06 and moved down to 23 per cent in FY10. There are four reasons for banks to cheer.

First, the freedom to price around a quarter of available funds gives them better control over an important section of their funds. Second, free pricing helps banks manage their costs more efficiently because they can fine-tune them depending on their own requirements and market conditions. The fact that these deposits are almost constant can give most banks flexibility in pricing, although ironically the mirror image would offer scope for competition to dip into them. Third, banks can increase or decrease this reservoir of funds to the extent that is possible based on their own requirements. This will foster competition between banks and enable them to compete with liquid mutual funds, which are the direct alternative. Also by changing terms of transactions like minimum balance, charges for services and so on, they can encourage or discourage such deposits. Finally, as a consequence of these three factors, asset-liability management becomes easier since banks can factor movement in these deposits to match maturity of assets.

Though it is true that these deposits have been an almost constant factor for the banking system, these dynamics may change gradually once customers see differential interest rates. One cannot conjecture whether this proportion of 23 per cent will move up or down when rates change. This was also observed when banks started very short-term deposits of 15 days and above — a move to get customers to roll over these deposits at a rate that was higher than the savings account rate. Customers did move funds to banks offering higher rates on these deposits. By offering higher rates on savings accounts, there could be migration to these deposits not just within the bank, but also across banks. This will cut administrative costs. Therefore, at the micro level, banks will have scope to play with their balance sheet more effectively.

Individuals usually hold cash at home for liquidity, savings deposits for security and convenience, and term deposits for income. While funds may be swapped between banks or across deposits, the overall amount of deposits may not change if rates are increased, given the profile of customers who are already exposed to various alternatives. Therefore, at the macro level the impact may be minimal since it should be recognised that liquid debt funds tend to give higher post-tax yields. Similarly, if the rates come down, customers may not actually withdraw substantially from this account.

We have already seen disparate reactions from banks. The large ones have been silent, while some smaller ones have increased these rates. This will really be the challenge for banks at the micro level where the share of savings accounts is lower, as in the case of foreign banks (about 15 per cent) and old private banks (around 19 per cent). Those that are already at 23-24 per cent may not really have scope to do so, based on past trends in terms of garnering deposits. The onus will be on banks to actually manage this portion of funds.

So, is it good for the banking system? Certainly yes, since it gives banks the freedom to manage their funds more adroitly. The consequences of the impact on the amount of deposits may not change but as long as it is market-determined, the system will be efficient. The real challenge is for the Reserve Bank of India when interest rates come down substantially — as they did in 2002-2005 when term deposits gave returns of around five per cent. Logically, the savings rate should have also come down proportionately to close to nil in case a spread of, say, 400-500 basis points is to be maintained as is the case today.

This may be tough to accept.