Why are Savings Bank interest rates deregulated?

Rama Krishna Vadlamudi, HYDERABAD 30 October 2011

www.ramakrishnavadlamudi.blogspot.com
Reserve Bank of India has given freedom to banks to set their own interest rates on Savings Bank deposit accounts. Till now, SB deposit interest rates were decided by RBI and banks offered RBIs uniform rate to SB accountholders. On 25 October 2011, RBI announced deregulation of SB interest rates with immediate effect. The same day, Yes Bank raised its interest rate on SB deposits by 200 basis points (or two per cent) to six per cent. Let us analyse certain issues related to the deregulation of SB interest rate. What is interest rate deregulation? As banking sector regulator, Reserve Bank of India used to set interest rates for deposits and all banks used to offer uniform rates to depositors depending on maturity periods. Deregulation is nothing but giving more freedom to banks to offer their own rates. Allowing banks to have more autonomy, RBI had undertaken the process of deregulation and started giving freedom to banks to offer their own rates in 1992. Except Savings Bank deposit interest rates, all the deposit rates were deregulated by RBI in 1997. On the lending side, the rates on small loans up to Rs 2 lakh and rupee export credit were deregulated in July 2010, when Base Rate was introduced replacing the benchmark prime lending rate (BPLR) system.

Rama Krishna Vadlamudi, Hyderabad 30 October 2011 www.ramakrishnavadlamudi.blogspot.com

Why are Savings Bank deposits so important for the economy? Household financial assets are 10.4 per cent of Indias GDP (200809). Share of SB deposits is 12.8 per cent of total household financial assets. Total SB deposits were around Rs 8.96 lakh crore as at the end of March 2009. Around 85 per cent of SB deposits are held by household sector which include senior citizens, small savers, pensioners, salaried class, small businessman, and others. Why did RBI deregulate Savings Bank interest rates? The deregulation of SB deposit interest rates is part of the process of financial sector reforms and bank autonomy initiated by RBI in 1992. RBI wants to make SB Deregulation will stimulate better product innovations. deregulation will improve transmission. deposits more attractive to savers. banks to offer more SB products and RBI expects that the SB interest rate the effectiveness of monetary policy

In view of the above, RBI had deregulated interest rates on SB deposits with immediate effect when it announced the second quarter review of monetary policy on 25 October 2011. Are there any conditions? RBI has imposed two conditions on the banks while allowing freedom to set their own interest rates on SB deposits. They are: First, each bank will have to offer a uniform interest rate on savings bank deposits up to Rs one lakh, irrespective of the amount in the account within this limit Second, for savings bank deposits over Rs one lakh, a bank may provide differential rates of interest, if it so chooses. However, there should not be any discrimination from customer to customer on interest rates for similar amount of deposit.

Page 2 of 7

Rama Krishna Vadlamudi, Hyderabad 30 October 2011 www.ramakrishnavadlamudi.blogspot.com

This means banks cannot offer different rates based on area, like, metropolitan city, semi-urban or rural areas. Moreover, a bank cannot offer different rates, say, for one depositor with Rs 25,000 balance and another with Rs 70,000 balance (that is, for balances below Rs one lakh). However, a bank can offer one rate to a depositor, say, with Rs 150,000 balance and another rate to a depositor with Rs 200,000 balance (for depositors with balance above Rs one lakh). Whether the deregulation is applicable to NRE and NRO accounts? Interest rate on Non-Resident (External) Accounts Scheme and Ordinary Non-Resident Deposit under savings account, which has been prescribed at four per cent per annum at present, will continue to be regulated until further review, according to RBI. Will banks raise SB interest rates? The competition will surge among banks for SB deposits, which are low-cost. Already, Yes Bank raised the rate to six per cent the same day RBI announced the deregulation. State Bank of India has stated that it may raise SB interest rate by 100 or 125 basis points (1.00 per cent or 1.25 per cent). The proportion of SB deposits in total deposits is very low for banks, like, Yes Bank, IDBI Bank and Kotak Mahindra Bank. As such, they may offer more rates to their depositors to increase their share of lowcost deposits and increase their market share. Banks, like, SBI, HDFC Bank, Punjab National Bank, and Axis Bank are having higher share of SB deposits in their total deposits. They too will raise the rates on SB accounts to protect their market share. As of now, the liquidity is in deficit mode meaning that banks are struggling to access short-term funds and they are turning to RBI for their day-to-day operations. It would be interesting to watch the response of the banks when there is excess liquidity in the system. As was observed during the 2002-2005 period, banks drastically reduced their term deposit interest rates to as low as 5.5-6.5 per cent.

Page 3 of 7

Rama Krishna Vadlamudi, Hyderabad 30 October 2011 www.ramakrishnavadlamudi.blogspot.com

It is hoped that the deregulation of SB deposit rates will not lead to unhealthy competition among banks. Banks are expected to manage the risks involved in asset-liability mismatches in a better manner even after the deregulation of SB interest rates. Even though, SB deposits are supposed to be short-term in nature, a major portion of SB deposits is treated as core deposits by banks and banks use SB deposits also to lend to long-term loans. Who will be benefited by the deregulation? As of now, banks are in need of more funds (deficit liquidity). So, they may increase their SB interest rates to attract more customers and funds. This is clearly a benefit to savers at present. With increased rates, banks will be able to attract new customers who will have more choices now. Many SB customers use the account for their day-to-day transactions. Some wealthy customers keep high balances and higher SB rates will allow them to earn more interest on their SB balances. If the difference between interest rate on term deposits and SB interest rate is wide, savers will shift their money from SB to term deposits. However, if the difference is small, they may keep their money in SB accounts without bothering about term deposit rates. At present, term deposits carry interest rates of 8 to 10 per cent, which is stimulating depositors to keep more money in term deposits rather than in SB accounts. The benefit to existing customers who are having sweep facility may not be large. Sweep facility in SB accounts allows the customers to move excess money beyond a certain limit to fixed deposits; and to move the fixed deposit amount back to SB account when a customer issues a cheque or needs funds. The flipside of deregulation is that when banks are not in need of funds (surplus liquidity), they may decrease the interest rates on deposits both term deposits and SB deposits. In such situations, interest rate differential between term deposits and SB deposits may come down lessening the attractiveness of SB deposits as happened during the 2002-2005 period.
Page 4 of 7

Rama Krishna Vadlamudi, Hyderabad 30 October 2011 www.ramakrishnavadlamudi.blogspot.com

How does the rate hike impact banks? Cost of SB deposits has already gone up for banks before the SB deposit interest rate deregulation. From April 1, 2010, banks have been giving interest rates on SB account based on daily product. With effect from 3 May 2011, banks have been paying four per cent interest rate on SB deposits compared to 3.5 per cent earlier. The cost of SB deposits will further go up from now with the advent of competition from SB interest rate deregulation. Different banks will get impacted differently depending on several factors like, branch location, nearness of branch, facilities provided under SB accounts, technology platform, and alternative delivery channels. It remains to be seen whether banks will pass on the higher cost of funds to customers. Depending on the competition, banks may increase their transaction and service charges for SB customers. However, there are limitations to passing on the higher costs as any adverse reaction from depositors will cause reputation risk to banks. Banks which are enjoying higher net interest margins (NIMs) may absorb the higher cost from hike in SB deposits themselves for the time being. What should investors in bank stocks do? As has been pointed out earlier, the SB interest rate deregulation and the consequent increase in cost of deposits will impact banks differently depending on the number of branches, branch location and quality of service. Quality of service, branch location, branch network and product design play a major role in customers choices. For example, Yes Bank is having around 200 branches. The bank may be able to attract new SB customers to its fold in locations where it is having branches. However, it cannot pose any threat to banks in other locations unless it expands its branch network to those locations.

Page 5 of 7

Rama Krishna Vadlamudi, Hyderabad 30 October 2011 www.ramakrishnavadlamudi.blogspot.com

Issuance of new bank licenses will take some more time if one considers the long process of decision-making on the part of regulators and lawmakers. Real action will start when new banks enter the fray after the new licenses are issued by RBI. Competition has two sides to it both positive and negative. The impact from competition hinges on individual banks agility. In view of the above, it may take more time before the real competition starts to hurt the existing banks which enjoy higher share of SB deposits. As such, investors in bank stocks need not panic provided they are holding stocks of fundamentally sound banks. Criticism of the SB rate deregulation The deregulation of SB deposit interest rate has attracted criticism from several quarters. Some critics questioned the timing of the deregulation. Banks which enjoy higher share of SB deposits are not comfortable with the deregulation. There are several rates in the system, which are not deregulated distorting the interest rate environment in the economy. The interest rates on public provident fund (PPF), provident fund, national savings certificates (NSC) and post office deposits continue to be administered by the Government of India. These rates do not move in line with the market interest rates (These rates were last changed in 2001/2002). As such, there is a need to have a relook at all the administered interest rates in the country and make them market-determined as has been suggested by various committees in the past. --References: RBI Abbreviations: GDP Gross Domestic Product or national income.

Page 6 of 7

Rama Krishna Vadlamudi, Hyderabad 30 October 2011 www.ramakrishnavadlamudi.blogspot.com

Appendix
Some important data for 2008-09: Gross domestic savings are 32.5 per cent of GDP at market prices. Household sector savings are 22.6 per cent of GDP. Out of the household sector savings, financial assets are 10.4 per cent of GDP and the remaining are physical assets. Share of total bank deposits is 54.9 per cent of total household financial assets. Share of savings bank deposits is 12.8 per cent of total household financial assets. Share of currency is 12.5 per cent of total household financial assets. As at the end of March 2009, total savings bank deposits are around Rs 8.96 lakh crore. What is monetary policy transmission? Whenever RBI raises or lowers policy rates, banks are expected to revise their interest rates in tune with the RBI. The intentions of RBI will be carried through the commercial banks to the entire economy. Banks pass on the RBIs policy measures either by increasing the lending and deposit rates or by lowering them in tune with the RBIs policy measures. This is called Monetary Policy transmission. Effective monetary policy transmission entails that all rates must move in tandem with RBIs policy interest rates. This process is hampered if any interest rate is regulated. Savings Bank deposits constitute around 22 per cent of total deposits (2009) and as such SB interest rate deregulation is important for effective monetary policy transmission.

Note on author: Author is an investment analyst and writer. The views are personal and this is written only for information purpose. Readers are advised to consult their certified financial adviser before taking any investment decisions. Authors articles on financial articles can be accessed at: www.ramakrishnavadlamudi.blogspot.com

Page 7 of 7