Decoding savings rate deregulation and how it impacts liquid funds

The Reserve Bank of India (RBI) in its second quarter monetary policy review deregulated savings bank rates with immediate effect.

A savings deposit is a hybrid product which combines the features of a current account and a term deposit account. A current account is mainly maintained by business houses whereas a savings account is used mostly by individuals.

The amount maintained under a current account normally does not provide any rate of interest whereas interest is paid for asavings account. The overall interest rate scenario has changed drastically in the last two decades, but the interest rate on saving accounts has been changed only thrice since 1978.Let’s take a look at the pros and cons of interest rates deregulation.

Advantages

To increase the share of savings account in total deposit: The savings rate was fixed at 3.50% from March 2003 to May 2011.

However, during the period, the RBI changed both repo and reverse repo rates many times but the same was not reflected in the interest rates that the normal household gets. There was a huge gap between savings and term depositrates and, hence, the ratio of savings deposit in total deposit fluctuated, mainly in rural areas. The deregulation would make such accounts more attractive in rural areas.

RBI policies would become more effective: As savings accounts constitute around 22% of the total bank deposits, it provides a source of low-cost fund to banks. Even when the reporate was hovering around 8.25%, the savings rate was fixed at 4% before deregulation.

After deregulation, it is expected that savings rate would move in tandem with the RBI monetary policy, thus, making the policy more effective.

Competition: Most banks would want to maximise their CASA ratio as it provides funds at low cost. Before deregulation there was hardly any competition in this segment. But after deregulation, it is expected that banks would try to lure customers by offering higher interest rates along with other innovations and flexibility to get as many accounts as possible.

Disadvantages
It might lead to asset-liability mismatches: As all banks offered similar rate of interest before deregulation, there was no incentive for customer to shift their savings from one bank to another and, hence, banks used such deposit to finance long-term loans. But, when the banks are free to set their own interest rates, it can wisely be assumed that banks with lower CASA ratio would offer attractive rate of interest to consumers, thus, leading to asset-liability mismatches.

Could impact small households: When interest rates are deregulated, it could be on the downside as well. Banks would not be in a position to compensate savers properly if there is enough liquidity in the system. This would impact small savers and pensioners who depend only on savings rate interest for their livelihood.

Unhealthy competition and systematic risk: Saving deposits offers low cost of funds and, hence, are very attractive for banks. To lure customers, each bank would try to offer higher rate of interest, thus, impacting their net interest margin. It would result in higher cost of funds for the bank which would ultimately be passed on to the borrower, leading to higher cost of borrowing. Deregulation of interest rates has its own pros and cons and it would be interesting to see what strategy banks adopt. It is expected that in a higher interest rate scenario they would be forced to provide much higher returns.

Impact on liquid funds
Liquid funds are mutual funds that primarily invest in debt securities and offer higher post-tax returns as compared to savings deposits. They normally invest in commercial papers, certificate of deposits and treasury bills of maturities less than 91 days. Their mandate is to optimise returns while preserving capital.

But with deregulation of interest rates in savings accounts, some investors might move their funds towards these as it offers higher liquidity and safety of the principal amount. The overall corpus might be impacted by reduced difference between yields of both options.

However, liquid funds yield better returns if we take tax rate into account. It also provides a dividend option where only dividend distribution taxis deducted by fund houses before distribution. With deregulation, this category of mutual fund will definitely offer more innovation. Thus, one must spread his savings across liquid funds and savings account to get the benefit of both

While savings deposits are easier to access and offer some degree ofprotection, higher yield combined with liquidity and taxation benefits make liquid funds attractive.

Source: http://www.dnaindia.com/money/report_decoding-savings-rate-deregulation-and-how-it-impacts-liquid-funds_1606196