Most of the discussions on the Reserve Bank of India’s (RBI) ‘Discussion Paper’ on deregulating the interest rate paid by banks on savings deposits have focused on the micro level; on what deregulation could mean for individual savers and borrowers.
There has been virtually no discussion on what deregulation could mean for the safety and stability of banks. Yet, the final verdict on whether this is the right time for deregulation hinges critically on the second rather than the first.
As far as the impact on individual savers and borrowers is concerned, opinion is unanimous that deregulation will spell the death-knell of the present system of a uniform, administered rate that bears little relation to underlying demand-supply conditions.
Not only will rates be more market-related, they will also vary from bank to bank, depending on each bank’s needs and strategy. To the extent rates will move up and down, as with any market-related rates, for savers there is trade-off between an assured (if low) rate of return and one that could, theoretically at least, be almost as volatile as the stock market.
So, in situations of tight liquidity, savings bank depositors could see the interest rate on their deposits go up and when liquidity is plentiful, rates could fall, other things remaining constant. The problem is liquidity is not only a function of borrowers’ demand for funds; it is also a function of the central bank’s management of liquidity.
So, in situations like in most of 2009 and 2010, when the RBI chooses to keep the system flush with liquidity, interest rates might not reflect the true supply-demand imbalance. Consequently, there is no certainty that deregulating rates will necessarily give savers a better deal.
But yes, to the extent the savings bank (SB) deposits interest rate is the only regulated rate and has remained unchanged at 3.5% since March 1, 2003 even as the RBI’s policy rates have moved up and down over time, there can be no case for continuing with an administered interest rate. Moreover, savings deposits account for about 13% of financial savings of the household sector. Presumably, deregulation will improve monetary transmission.
In the present context, it will raise both real and nominal rates. It will also encourage product innovation as banks will try to compete, not only on rates, but also on product design as, for instance, by offering differentiated rates depending on the size of the deposit (something they are not allowed to do at present).
International experience too suggests there are gains to be had from deregulation. In Hong Kong, for instance, interest rate deregulation increased the efficacy of monetary policy by improving the correlation between retail bank deposit rates and market interest rates. Besides, savings rates are not regulated in developed markets (though there are usually strict limits on the number of transactions permitted).
Thus, the theoretical arguments for deregulation are sound. What is less clear is whether these gains, both at the micro and at the macro level, will be outweighed by the fallout of deregulation on the composition of banks’ deposits.
Will the resultant volatility in savings bank deposits (that constitute a significant part of a bank’s 'core' deposits) increase the vulnerability of banks, given their relatively large exposure to long-term loans? The reality is many banks have used short-term funds like savings deposits to make long-term loans, confident in the belief that these are 'core deposits' that will not be withdrawn.
Never mind that, on paper, these are deposits that can be withdrawn on demand. That belief was not without basis in a scenario where a low and uniform rate of interest made savers 'lazy'. But deregulation could change that. Once banks begin to compete for funds based on interest rates, these deposits lose their ‘core’ element. This could jeopardise the safety of banks by widening the maturity mismatch between their assets and liabilities. The discussion paper does raise this issue but is confident the downside is limited.
But with savings bank deposits accounting for 22% of total deposits of scheduled commercial banks, we could be skating on thin ice. Deregulating the SB interest rate could see substantial swings in savings bank deposits in individual banks in response to interest rate changes. Banks will be hard put to determine what is ‘core’ and can be used to make long-term loans and what is ‘fleeting’ and not to be lent for longterm purposes.
It is significant that the share of term loans has increased during the period 2000-09 even as the share of term deposits has come down, suggesting maturity mismatches have widened during this period. The ball is, therefore, in the RBI’s court. As banking sector regulator, if it feels the fallout in terms of maturity mismatches will not derail banks, it should go ahead. But not unless it is very sure! Else it should bide its time.
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