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Deregulation or Destabilisation?

It seems that the Reserve Bank of India has taken a silos approach in deciding to deregulate the interest rate on savings bank accounts. The decision is likely to unsettle the banks, leaving the deposit holder no better than before.

COMMENTARY

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Deregulation or Destabilisation?

K Subramanian

It seems that the Reserve Bank of India has taken a silos approach in deciding to deregulate the interest rate on savings bank accounts. The decision is likely to unsettle the banks, leaving the deposit holder no better than before.

K Subramanian (subrabhama@gmail.com) retired from the Union Ministry of Finance.

Economic & Political Weekly

EPW
december 3, 2011

T
he rate on savings bank (SB) accounts has remained rock steady. The balances in SB accounts have also been growing over the years. Efficient market theorists may wonder why? Way back in 1978, the interest rate was 4.5% and in September 1979 it was raised to 5%. From that year until April 1992 it was steady at 5% and was then raised to 6%. Indeed, this was the peak rate for the poor SB account holders in our times. The story of its decline and fall started in later years.

Erosion of Earnings

In 1993, it was reduced to 5% and down again to 4.5% in 1994. It remained at that level until April 2000 when it was lowered to 4%. In March 2003, it was pushed further down to 3.5% where it vegetated for eight years until May 2011 when it was raised to 4%. One may not ignore the small mercies granted in April 2010 when the Reserve Bank of India (RBI) advised banks to pay interest on daily basis instead of the arbitrary manner in which they were crediting interest to SB accounts.

To add insult to injury, banks collected various charges, direct or indirect, which tended to erode earnings. There was no uniform standard followed by banks, nor any guidelines or norms set by the RBI. Adding further to their woes, the impact of inflation reduced the real rate further. Truth is that at current rates of inflation, SB depositors have been getting negative returns. Ashis Das of the Indian Institute of Technology Bombay

vol xlvi no 49

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has brought this out graphically in his studies. As he explained,1

based on WPI [wholesale price index] infla

tion data, we see that every time the real

rate turned positive the regulator reduced

the SB rate, never to take corrective action

(in terms of increasing the SB rate) even on

subsequent high negative real rates...From

2003 to 2009 the real rates on SB accounts

remained at historically low levels and per

sisted there for six years.

Surprisingly, despite the shabby treatment meted out to small savers, SB deposits have grown over time. In its discussion paper,2 the RBI observed how average annual rate of savings deposits which had decelerated in the 1990s when compared with the 1980s “accelerated sharply in the decade of the 2000”. In this decade, the average growth of savings deposits exceeded that of both demand deposits and term deposits, notwithstanding the growth in term deposits outpacing that of savings deposits during the period 2005-10. It gives an account of savings account penetration which remained broadly unchanged between March 1996 and March 2005 and increased significantly by March 2009.

Savings Account Penetration

Data for the last three years ending 2010-11 show that SB accounts or what are classified as current account and savings account (CASA) in banks’ books constituted 20-29% of all deposits. The Financial Stability Report (FSR) 20113 issued by the RBI in June 2011 estimated CASA deposits at 35%. In magnitude, the total CASA accounts were estimated at Rs 13 lakh crore parked as SB deposits and Rs 4.5 lakh crore as current account deposits.

An interesting feature of CASA deposits is that their distribution is highly skewed. Data given in the FSR suggest that public sector banks hold over 30%, while new private banks and foreign banks hold

COMMENTARY

around 40%. (These percentages are in relation to total deposits.) The ratio of CASA to total deposits varies from bank to bank. Broadly, in the past, public sector banks attracted more deposits, perhaps due to the psychological security offered by government ownership and guarantees. However, in recent years their loyalty seems to be shifting.

It is intriguing how when the reform agenda was the name of the game and financial reforms were at its heart, SB accounts escaped the reform radar. One benign interpretation is perhaps that the government and the RBI were more keen on freeing other rates and setting the cart firmly before enlarging it and bringing the SB accounts into its ambit. Further, SB accounts affect a large number of people and even for diehard reformers there is the fear that the process could hurt the lower income groups and upset the apple cart. It is not surprising that “financial inclusion” became the battle cry alongside reform tunes. And they could afford to keep the SB deregulation in the bottom drawer.

Monetary and Credit Policy of RBI

The RBI did take up the issue for consideration in 2002 and expressed its views clearly. In its monetary and credit policy for 2002-03, it said that in the environment of deregulated interest rate there was an apparent case for deregulation. It took the view:

However, considering the fact that bulk of such savings are held by households, including households in rural and semi-urban areas, on balance, it is not considered as opportune to deregulate the interest rate on savings account for the present.

It decided that the then effective rate of 3.4% was reasonable in relation to interest rates on short-term instruments.

The RBI examined the issue again in its monetary and credit policy for 2006-07. It was dismissive of deregulation and said,

Based on a view of current monetary and interest rate conditions, including a careful consideration of the suggestions received from the IBA [Indian Banks Association], it is considered appropriate to maintain the status quo while recognising that deregulation of this interest rate is essential for product innovation and price discovery in the long run.

New from SAGE!

After this review, the issue would lie in the coffin for four years.

For no known reason, it was given a new life in the Second Quarter Review of Monetary Policy for 2010-11 announced on 2 November 2010. The RBI drew attention to the deregulation of interest rates on all deposits other than SB and felt the need for progressive deregulation including the interest on SB accounts. It undertook “to prepare a discussion paper which will delineate the pros and cons of deregulating the savings bank deposits interest rates” to elicit feedback from the general public.

The discussion paper was posted on the website of the RBI on 28 April 2011. Pending public response and examination of the issue, the RBI raised the interest rate on SB accounts from 3.5% to 4%. It was in the Second Quarter Review issued on 24 October that the RBI announced its decision to deregulate SB rates.

The RBI’s papers and studies are generally scholarly and draw on a variety of academic and banking expertise. Sadly, the analysis of SB deregulation in the paper

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december 3, 2011 vol xlvi no 49

is superficial if not cavalier. It explained how it “evoked wide-ranging responses from a cross-section of stakeholders, ranging from the suggestion that savings bank deposits should not be deregulated to the suggestion that it should be deregulated completely”. It goes on to add that the RBI had weighed the pros and cons of deregulation and felt, on balance, that “the time is ripe to move forward and complete the process of deregulation of interest rates”. Is the timing ripe or appropriate? There are serious doubts.

Response to Deregulation

The response to deregulation has been varied. Some of the western analysts are enthusiastic over deregulation. News reports clearly indicate that the IBA is a divided house. It is evident that public sector banks are against deregulation. One official of the SBI said,4 “from a customer’s point of view, it may look like a good measure, but deregulation will lead to volatility in the banking system it will lead to rate wars among banks. Moreover, customers in India are getting better

returns on savings accounts. In countries such as the US, a customer gets 1% to 2% on deposits.”

There are several reports and studies which indicate the impact of deregulation on the course of interest rates and on the balance sheets, especially profit ability and asset liability management (ALM). One analyst estimated (Munshi 2011) that the “additional interest that banks need to pay on savings will reduce the profitability (of the entire) banking sector by 12.85%”.

There are genuine concerns over the longer-term impact of SB deregulation. Though the RBI has attempted an examination of connected issues, its examination lacks depth and does not even capture the major concerns expressed in its own FSR issued in June 2011.

Unhealthy Competition

Some banks have expressed a concern over unhealthy competition that could come about with deregulation. The RBI dismisses it on the experience of deregulation of other deposits done in the earlier years. Unfortunately, there is no parallel between the two. While dealing with

Economic Political Weekly EPW december 3, 2011

other deposits (terms deposits, time deposits and dated securities, etc), the major endeavour of the RBI was to bring about a system of prime lending rates (PLR) which is not replaced by base rate (BR). It cannot be said that the PLR (or the latest BR) has brought about dispensation of funds at a rate expected of a “free market” or those demanded by India Inc. The RBI continues to grapple with issues like discrimination (lending at sub-PLR), opacity, etc. It is a work in progress and the RBI will have to continue its battles with the BR (Subramanian 2009).

In the context of PLR, it was observed that the banks had to grapple with legacy costs and other elements attached to funding costs and they were greatly helped by the availability of low cost funds, i e, CASA. In the absence of CASA, the PLR or BR will not remain where it is currently. Rock solid balances estimated at 90% of CASA provide the ballast to keep the PLR or BR at current levels. It was for this reason that it was treated as “core” in the ALM calculations. If CASA are deregulated they may not remain at the “core” and may turn volatile. Even in the latest guidelines5 issued by the RBI on the BR the illustrative methodology given for computation of BR includes “time deposits, current deposits and savings deposits”. When CASA is freed, is it theoretically permissible to treat them as “core”? One cannot eat the cake and have it too.

CASA are free funds which can flit from bank to bank in search of higher returns and

COMMENTARY

in the absence of a code of conduct among banks. Banks with low CASA ratios like Kotak Mahindra, Yes Bank and IndusInd have already hiked SB rate by 2%. Foreign banks will be more aggressive as they are not burdened with high CASA ratios. There is an assumption in the RBI analysis that deregulation may not generate unhealthy competition. This is questionable. Much will depend on the quest for liquidity in the context of the availability of liquidity through Liquidity Adjustment Facility (LAF) or other channels. Even in the US there are reports that there is a race for seeking deposits. As the Wall Street Journal reported (Silver and Pilon 2011), “historically low interest rates, tough new capital requirements and heightened competition among brokerage firms are prompting banks to dangle juicy incentives to a group of customers that not long ago were wall flowers: depositors”. They are said to offer cash drawbacks over and above interest payments.

Asset Liability Mismatches

The RBI dismisses “asset liability mismatches arising out of deregulation” as “misplaced”. This is based on the notion that CASA will continue to be “core” for ALM. As argued earlier, this is a pathetic fallacy. CASA cannot be treated as core once it is deregulated.

The other advantage the RBI hopes for is better transmission of policy rates. This is the angst of a central bank when its tools lose efficacy. It is more like an ageing

vol xlvi no 49

COMMENTARY

wrestler flexing his muscles to prove his prowess. If the deposits, other than SB, which constitute a higher share of deposits, have not helped in bringing about transmission of policy rates, the tail of SB deposits may not be expected to bring it about. In any case, rate transmission is a tricky area and even in countries like the UK, the transmission takes place after a lag or not at all. In the US, a regime of zero interest rate and the flooding of QE2 funds have not brought about credit transfers to industry.

It seems the RBI has taken a silos approach in analysing the issues disregarding its own big picture given in the FSR. The FSR flags many major concerns affecting the stability of our banking system. The overarching ones are about lack of liquidity (or tight liquidity conditions) and increasing reliance on borrowed funds. The concerns about liqui dity flow from the growing maturity mismatches in conjunction with a reduction in the share of liquid assets to total assets. As the FSR explains, “concerns about increasing reliance on borrowed funds were further exacerbated by growing mismatches in the maturity profile of deposits and advances...These mismatches entailed considerable rollover risks for banks.” FSR clearly admits that concerns over reliance on market borrowing “were alleviated by the accessibility of banks to stable low cost deposits (current account and savings account-CASA deposits)which stood about 35% of total deposits”.

In short, CASA deposits have provided the life boat to our banks in their struggle to meet the current challenges. If the life boat is taken away, what will be the consequences? The liquidity problem has plagued our banks even after the Lehman shock was absorbed through the provision of liquidity of Rs 80,000 crore. Apart from worries over asset liability mismatches, our banks need to be on guard against currency mismatches. There are growing concerns over concentration of assets in retail, commercial estate and infrastructure sectors. In meeting some of these challenges they have been helped by the availability of low cost funds.

Rating agencies are already on the prowl to downgrade premier banks like the SBI. The government is struggling to provide support through budgetary transfers to improve their capital adequacy ratios. At such a juncture if they are deprived of CASA funds, it will hurt their interests more and deregulation may result in destabilisation. It may satisfy the whim of undertaking reform, but may not serve any larger purpose.

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Notes

1 Das, Ashis (2011), “Savings Bank Accounts: Interest Rate Deregulation”, IIT Bombay Technical Report, May, available at http://dspace.library.iitb. ac.in/jspui/handle/10054/1734

2 Reserve Bank of India (2011a), “Deregulation of Savings Bank Deposit Interest Rate: A Discussion Paper”, available at rbidocs.rbi.org.in/rdocs/Content/PDFS/DPS270411F pdf

3 Reserve Bank of India (2011b), Financial Stability Report 2011, June, available at rbidocs/rbi.org.in/ rdocs/Publications Report/Pdfs/FSR 140611 FL pdf

4 Shruti Verma (2011), “Banks Oppose Free Saving Rate”, 24 October, available at http://www.mydigitalfc.com/print/97402

5 Reserve Bank of India (2010), “Guidelines on Base Rate”, RBI/2009-10/390 dated 9 April.

References

Munshi, Neil (2011): “India’s Banks: A Much Needed Short in the Arm – or One in the Foot?”, Financial Times, 25 October.

Silver, Jessica and Mary Pilon (2011): “The Great Customer Courtship”, The Wall Street Journal, 12 February.

Subramanian, K (2009): “Battle against the Prime Lending Rate”, Economic Political Weekly, 21 November, Vol XLIV, No 47.

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december 3, 2011 vol xlvi no 49

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