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Towards A Free-Floating Rate

We analyse the impact of recent increase in savings deposit rate as a precursor to its deregulation…

After nearly eight years, the Reserve Bank of India (RBI), in its annual policy review, revised the interest rate on bank savings deposits by 50 basis points (bps) from 3.5 per cent to 4 per cent per annum. This rate was last revised on March 1, 2003. The current rate hike raises two questions: will this move make savings accounts more attractive, and should they be used as investment instruments?

Earlier, RBI had also asked banks to pay interest on savings bank accounts on a daily basis with effect from April 1, 2010. Prior to the introduction of the daily product method, interest on savings deposits was calculated based on the minimum balance maintained in the account between the 10th day and the last day of each calendar month. Interest was credited only when it amounted to one rupee or more. After the change, the effective interest rate on savings bank deposits has increased, thereby benefiting depositors.

More attractive now?
The hike in savings account rate may not translate into real gains for investors, according to Pune-based financial planner Veer Sardesai. According to him, the revision really does not change much since the savings deposit still gives negative real returns. While the interest rate on the savings account is 4 per cent, the inflation rate (as on April 30, 2011) stood at 7.7 per cent. Thus the depositor still earns a negative real return of 3.7 per cent. In its monetary policy statement for 2011-12, RBI stated that its baseline projection for WPI inflation for March 2012 is 6 per cent. Therefore, the yield on savings deposits will continue to remain negative for some time in the future as well. Despite the recent hike, the investor will not be able to counter the impact of inflation by putting his money in a savings account.
However, the rate hike will bring marginal benefit to small savers who put all their savings in a savings account.

An investment tool?
Given the negative real returns that it earns, the savings account does not seem to be a good investment tool. Sardesai advises that investors could keep their money in a saving account that is linked to a fixed deposit (FD) so that any amount over, say, Rs20,000 becomes an FD. In the annual credit policy, the central bank hiked key policy rates (repo and reverse repo) by 50 bps. In response, most banks also raised both their lending and deposit rates. Therefore, by putting their money in fixed deposits, investors can enhance their returns.

Negative impact
Savings accounts are an inexpensive source of funds for banks. Paying more interest on the savings account will increase banks’ costs and adversely affect their margins. This could also affect their profitability adversely.

Deregulation of savings rates
The current revision of savings rate comes close on the heels of RBI circulating a discussion paper on deregulation of savings accounts. At present, the interest rate on savings accounts is regulated. It is determined by the central bank.
Deregulation of savings bank deposits has both pros and cons:
May enhance its attractiveness: Regulation of interest rates imparts rigidity to the instrument as rates do not change in response to changing market conditions, or change slowly. The savings deposit rate has remained unchanged since March 2003 even as the RBI’s policy rates and call rates have moved significantly in both directions. When rates rise in the economy, savers lose out if they keep their money in a savings account.
According to RBI’s discussion paper, “Since savings bank deposits in rural, semi-urban areas and urban areas are held largely for savings purposes, deregulation of interest rate is likely to enhance its attractiveness in these areas.”
Moreover, empirical evidence suggests that widening of the interest-rate differential between term deposits and savings deposits leads to reduction in the share of savings bank deposits in total deposits.
Improved transmission of monetary policy: According to the paper, regulation of savings interest rate has also adversely affected the transmission of monetary policy. “For transmission of monetary policy to be effective, it is necessary that all rates move in tandem with policy rates,” adds the paper.
May lead to product innovation: Deregulation of the savings deposit rate is expected to lead to product innovation. Banks are expected to offer varied interest rates on the savings account depending on which channel the customer uses — bank branch, ATM or the Internet — because interacting with the customer via each of these channels imposes different levels of cost on the bank (with a bank branch being the most expensive and Internet the least). Banks are also expected to begin offering varied rates of interest on the savings account depending on the amount of money held in it.

Possibility of unhealthy competition: A major attraction of savings deposits for banks is that they offer a low-cost source of funds. After the deregulation, one could witness the outbreak of a rate war among banks to garner more savings deposits. This could affect the stability of the banking system (if some banks offer a more-than-viable rate of interest). Moreover, such unhealthy competition would push up the cost of funds for the entire sector. This, if passed on to the borrower, will raise the cost of borrowings. And if the cost is not passed on, then the interest margin and profitability of banks would be affected.
Risk of asset-liability mismatch: Savings deposits are short-term savings and customers can withdraw their money on demand. In practice, however, a lot of the money in savings accounts remains untouched for long. Banks call this portion of savings deposit as core deposit. Together with the money in term deposits, they use core deposits to give out long-term loans.
If a rate war breaks out among banks and customers begin to chase rates, core deposits would no longer remain a reliable source of funding. A bank that has used a lot of core deposits to give out long-term loans could face an asset-liability mismatch.
Adverse impact on small savers and pensioners: Many senior citizens, pensioners and small savers depend upon interest earned by their savings deposits for regular income. Deregulation may push up the savings deposit rate higher, in which case they would benefit. But it could also at times result in the savings deposit rate plummeting. This would adversely affect the income of this class. At the very least, deregulation would increase the element of uncertainty in their financial situation.
May lead to financial exclusion: Another negative fallout of deregulation could be that with the cost of funds going up, banks may begin to discourage small depositors from maintaining an account with them in order to save on transaction costs with these small depositors.
Deregulation could also lead to mis-selling of the savings bank deposit.
But all this is only conjecture. What impact the deregulation of savings account rate will have on the banking sector and on customers will become apparent only once this step is implemented.