My friend Atul walked into my office recently. He had read that the Reserve Bank of India (RBI) had deregulated savings bank account rates. “How will this affect me or my finances?” he enquired.
“In order to fully ascertain the effects one needs to understand the role of a savings account in banking,” I replied.
In simple terms, the business of a bank is to accept deposits and lend the same to borrowers at a higher rate. The difference between the interest rate paid to the depositor and that charged from the borrower is the bank’s profit.
A savings account balance is considered to have two elements. First, is a deposit that remains in the account over long periods of time. Second, is a transaction balance that the customer uses to issue cheques and withdraw funds for his or her daily needs.
Atul nodded. He had understood the matter so far.
Banks and savings accounts
The savings account deposit component or “savings deposit” are funds that the bank can lend to its borrowers. In the past, the interest rate paid to savings bank account holders was very low at 3.5% per annum. As a result, banks found these accounts to be a good source of low-cost funds. Lending these funds to borrowers entailed hefty profit for the banks. Therefore, banks with a large number of savings accounts had an advantage over others.
However, since all banks offered the same regulated interest rates, customers had no incentive to move their accounts to new banks. With deregulated savings account rates, this is set to change. New banks can now offer a higher interest rate to persuade customers to move away from their old banks. But as can be visualized, the interest rates paid by all banks on their savings accounts will rise. This will adversely affect banks’ profitability, I continued.
“This means that banks will compete with each other on savings account interest rates. So a customer, like me, will benefit in the form of higher interest rates. That’s great. Why should I worry about the profitability of banks?” Atul asked.
“Good question,” I said and went ahead with the explanation. Just like all other businesses, banks have to try and maximize their profits. When banks had to pay just 3.5% as interest, they were able to give free chequebooks, allow free cash withdrawals and charge a nominal fee for other services. All these freebies were funded because they paid the depositors a low rate of interest. If banks have to remain profitable, they have two options. First, increase the lending rates to ensure the same profitability in spite of paying a higher savings account rate. Second, cut costs related to savings accounts.
Customers and savings accounts
In most other countries, where savings account rates have been deregulated, the effect on lending rate was minimal. Instead, the focus has been to reduce the cost of the savings account to the bank. A similar impact is being seen in India as well. YES Bank Ltd was one of the first to raise interest rates to 6% on savings bank accounts. Kotak Mahindra Bank Ltd followed with offering 6% on a minimum balance of Rs 1 lakh.
As can be seen, banks have increased interest rates to get more savings accounts. But at the same time, they will be forced to remain competitive by moves such as an increase in the minimum balance requirements, having a tiered interest rate structure (wherein better rates are offered to customers with a larger balance), imposing a charge for issue of chequebooks and so on, I said.
Atul looked shocked. He realized that the whole structure of savings bank accounts is set to undergo a major change. Customers will not only shop around for the best interest rate for the balance that they wish to maintain but will also need to know the charges applicable for mundane transactions that were taken for granted to be free.
Further, you will also see innovative products such as, savings accounts whose interest rates are linked to the inter-bank rate; something like a floating rate home loan but this time it’s not a loan but a deposit, I continued.
“So if interest rates move up or down the savings rate will also move accordingly. Is that true?” Atul queried.
Yes, savings rates can now move with interest rates in the economy. Today banks are offering an interest rate of about 6%. But this rate is likely to vary over time, I replied.
Atul smiled in amazement of how a small freeing of interest rates can result in such a large change in the product and product offerings. He thanked me and left.
Veer Sardesai is a certified financial planner and chief executive, Sardesai Finance.
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