The decision by the RBI to deregulate bank savings rate in its second quarter monetary policy review is one of the most progressive and efficiency increasing reforms in recent years. All banks are currently mandated to pay an interest of only 4% on savings account deposits.
In one stroke it eliminates one of the last remaining glaring incentive distortions in India's banking sector. With 26% of the total bank deposits (as on June 2011) being in the current and savings bank accounts, banks hitherto benefited hugely from an artificially lower cost of funds.
It is expected to increase depositors’ interest income by around Rs 9000 Cr. The Businessline reports that assuming the savings bank deposit rates of banks rise by 1 percentage point, profits before provisions and taxes will be lower by 9.3 per cent (based on FY-11 profits) if they do not pass on the deposit rate hikes to borrowers.
This decision increases competition, lowers entry barriers, encourages savings, and contributes to strengthening the financial markets and increasing the effectiveness of the monetary policy transmission channels. In simple terms, it is one of the rare policy decisions which aligns incentives of all stakeholders and increases overall efficiency of the system. Here is a summary of its benefits.
1. It will increase competition among banks and thereby increase all round efficiency in the sector. Banks will be forced into raising deposit rates so as to attract depositers and also allocating their lendings into the most profitable avenues.
2. It lowers entry barriers by working to the advantage of smaller banks and newer entrants. They have hitherto suffered from a system where location of branches conferred an unfair first-mover advantage. Now with the freedom to price their depsoit rates, these banks can hope to attract accounts by signalling with more competitive rates. This was evident in the immediate aftermath of the decision, with Yes Bank announcing hiking its deposit rates by 200 basis points.
3. It will force banks into diversifying into other transaction and advisory services which will in turn enhance the breadth of India's financial system. This will be felt with much greater force by the public sector banks who have a higher exposure to low cost savings bank deposits. Hitherto, the ceiling on deposit rates had provided banks with a large easy source of money and comfortable assured profits from it (SBI alone loses Rs 1500 Cr for every 50 basis points increase in deposit rates). To this extent, the incentives were not aligned towards getting banks to search for alternative sources of revenues.
4. On the consumers side, given the dominant role of banks in household savings, especially of savings bank accounts in case of the poorer people, this deregulation will enable them to get higher returns on their deposits. This will in turn boost household savings and also encourage people in rural areas to utilize bank accounts to channel and save their incomes. Banks too are certain to come up with more differentiated savings products.
5. It increases the effectiveness of monetary policy transmission mechanisms. As deposit and lending rates are arrived through a competitive process, any changes in the repo rates will, in normal times, is more likely to be transmitted quickly into the financial system and the economy.