Notwithstanding the fact that both corporates and bankers want interest rates to be lowered further, households have confronted a wall in terms of returns on deposits, which have come down to the extent that they are unattractive. The fact that the policy of banks is to make deposit holders ‘pay as you go’ ensures that all services are charged. The recent controversy regarding deposit holders being responsible for a pay-in if the bank balance sheet turns bad has added another dimension of fear in their minds. It is against this background that the recent shift from bank deposits to mutual funds should be viewed.
The accompanying table 1 shows how the weighted average interest rate paid on deposits moved in the last five years along with the weighted average spread for the banking system. The rates have been reckoned as of March of the year.
There are two distinct phases here, with 2015 being the turnaround year. Interest rates moved marginally downwards in 2014 and 2015, after which the decline was rapid. The period up to 2015 had the repo rate move up by 50 basis points (bps) and then lowered by 50bps, which explains the weak movement. Subsequently, the repo rate has come down by 150bps, while the weighted average cost of deposits was down by a little over 200bps. The curious point to note here is that the bank spreads, after coming down by 19bps in 2015, increased sharply by 70bps to 3.89% in October 2017. Evidently, banks have lowered deposit rates at a higher rate than their lending rates and increased their spreads, which could also be used to address the issue of making provisions for non-performing assets (NPAs). However, the story from the deposit holder’s point of view is that they have gotten a less-than-fair deal from policy changes.
An outcome of this changing interest rate structure is that there has been significant migration to the mutual funds market. Table 2 captures the changes in outstanding deposits for 2014-17 for the year ending March, while the last column looks at changes between March and December 2017. The same has been done for the assets under management (AUM) of mutual funds for the same period. There has been a continuous decline in the quantum of incremental deposits over this period, while AUM has increased sharply in FY17 and FY18 (nine months). In fact, FY17 was significant because deposits too increased sharply, mainly due to the demonetisation exercise where perforce cash had to be put in deposits. The fact that households went in for mutual funds at a higher rate indicates the shift in pattern of savings. Further, interest rate on small savings has also been lowered and is indicative that households are looking for higher returns on their savings.
A concern is that the shift to mutual funds has also moved towards equity-oriented funds, which, in turn, has helped to spike the stock markets at a time when foreign portfolio investors have had a preference for debt. Table 3 provides information on shares of various components of savings in bank deposits and mutual funds under various headings.
The share of bank deposits in incremental deposits plus mutual funds’ investments (i.e. incremental AUM) has been coming down continuously from 88.5% as of March 2014 to 73.3% in March 2017. Significantly, the decline in the first nine months of the year is quite stark, at 25.6%. Bank deposits have been yielding lower returns, which are also taxable; this makes them inferior financial products even for risk-averse households.
Table 3, in fact, reveals some interesting facets of investment preferences within mutual funds. Debt funds have been a close substitute for bank term deposits without the flexibility of withdrawal. In FY15, the share came down mainly due to the long-term capital gains tax being imposed by the Budget, with the condition of a lock-in of three years. But the sharp fall in bank deposits subsequently has made this avenue more popular, with a peak being reached in FY17, as demonetisation caused cash to be put in bank deposits and mutual funds at a fast rate.
The even more interesting part pertains to equity funds, which have suddenly become very attractive for households looking for higher returns. With most mutual funds giving returns of above 12-15% over time, the temptation to go in for equity-oriented funds has been high. The more conservative have gone in for balance funds, where at least 65% of investments are in equity, which hence end up giving a lower return than equity but higher than pure debt investment without the tax encumbrance. In FY18, exchange-traded funds too have been working well, especially the ones floated to invest in PSU disinvestment.
The danger here is twofold. High investments into equity schemes have made the stock market look more buoyant than convincing, as the economic data points do not justify such valuations. The second is that banks will face a major challenge going forward, unless they are able to increase their interest rates, which may mean compromising on spreads. If the deposit base does not grow, then lending will be an issue. In addition, as a substantial part of the incremental deposits flow to the government as statutory liquidity ratio investments, a liquidity crunch cannot be ruled out.
In fact, the current recapitalisation bonds scheme is predicated on banks investing their surplus funds in them, which will be a challenge.
From the regulator’s point of view, the possibility of major losses being incurred by the amateur investor when there is a correction in the market could lead to chaos should be a concern. While nothing can theoretically be done, it can lead to a major shake-out in this space.
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