RBI frees deposit interest rates

For decades, those who deposited their money in bank savings accounts had little choice - they got the same interest rate no matter which bank they chose, and predictably this rate of interest was low, as banks felt no need to compete among themselves for the deposits of investors. That may be about to change, with the recent notification by the Reserve Bank of India, freeing banks to determine their savings deposit interest rates.

In its 25 October circular to all scheduled commercial banks, the RBI issued new guidelines for savings bank deposits. The circular sets two conditions, subject to which banks may freely set their own rates. These conditions are that (a) for amounts less than Rs.1 lakh, the rate of interest shall be uniform to all account holders, no matter what the amount in the account is; and (b) the banks shall not discriminate between depositors who invest the same amounts on any given date.

The RBI also clarified that the freed rates are also limited, for the moment, to accounts held by resident Indians only, and accounts of non-residents would continue to attract regulated rates of interest (currently at four per cent).

Consumers can now look forward to competition between banks to get their savings deposit funds. In the coming weeks, it should become evident if banks are responding to RBI's move by hiking interest rates for deposits (the current rate of interest on savings depostis is 4%, set earlier this year). If that happens, hundreds of millions of bank accounts will yield better returns for their holders.

But where will this money come from? The bank 'spread' in India - the difference between the interest rate paid to depositors and the interest rate charged to borrowers by the bank - is quite high, compared to global norms. This has provided banks with a giant cushion across their operations. With this move by RBI, banks may find that their cost of funds obtained from depositors is no longer as low as it has been so far. To maintain the same level of profits, therefore, their loans to borrowers - e.g. businesses, mortgage owners - would have be that much more efficiently disbursed and managed.

Another result of the new rules could be higher churn in the deposits themselves - as customers move their money between banks to take advantage of better rates through comparison shopping. The rise of electronic transfers (one in seven transactions is now carried out online, up from just 1% in 2007, according to a McKinsey report, and this share is rapidly growing while the share of in-branch transactions is dropping) means that it is also quite easy to move money between banks, further requiring banks to work hard to retain their depositors in a competitive market.

For the RBI, this move is part of a broader pattern of reforms and deregulation it has been pursuing, to make financial services more accessible to all Indians and to give consumers better control over the application of their funds. Also this week, the central bank proposed to relax the rules for opening bank branches in Tier 2 towns (population above 50,000 but less than 1 lakh), which would allow the banks to set up their branches without first seeking the RBI's permission.

For consumers, who have in recent times been battered by inflation and rising interest rates for almost every kind of borrowing, the possibility of higher yields from their deposits is much-needed relief. But they will have to wait to see if the bounty really arrives. Banks may not be quite ready to give up the generous interest spreads they have enjoyed for decades.

Speaking at a recent press conference, Aditya Puri, CEO of HDFC Bank downplayed the impact of higher rates of interest paid to depositors by suggesting that the banks would correspondingly hike the rates they charge while making loans to borrowers. For businesses and home owners, that might feel like the other end of RBI's double-dged sword, taking away with one hand what has been given with the other.

Update - Yes Bank and Kotak Mahindra Bank announced increases in their savings deposit interest rates in response to the RBI's announcement, raising the interest offered to depositors by 2%. At least a few banks, it seems, are willing to pay more for their depositors' money.