In a surprise move the Reserve Bank of India has announced, in its Second Quarter Review of Monetary Policy, a decision to “deregulate the savings bank interest rate with immediate effect”. Interestingly, most commentators have reacted to this decision favourably. Two arguments have been advanced to support the move. The first is that it would serve depositors well, since it would now allow them to earn a higher return on savings held in such deposits. The second argument is that the RBI’s efforts to use increases in interest rates to moderate inflation has not worked because the transmission of increases in the Bank and or repo rates to the loan rates charged by banks is muted. Since banks have access to funds in the form of savings deposits on which the interest rate is fixed, the cost at which they obtain capital does not rise in proportion to the increase in the RBI’s intervention rates. So banks do raise interest rates on their loans, but not adequately, muting the effect of the policy on demand and inflation.

There is reason to believe that it is the second of these arguments that has influenced the RBI to resort to this move. Unwilling (and also unable) to restrict credit flow because of the fear that it will affect growth too adversely, the central bank has decided to maximise the impact on demand of the thirteen interest rate hikes it has announced in recent months. The RBI holds that the policy has been on the anvil and had been seriously considered a couple of times in the recent past. It had also issued, earlier this year, a Discussion Paper on “Deregulation of Saving Banks Deposit Interest Rates”, which though presenting the “pros and cons” involved, was all too clearly inclined towards the pros. Despite these early signals, the timing of the final decision was a surprise.

Savings bank deposits fall in between current account deposits that pay no interest since they are maintained largely for transactions purposes, and term deposits or fixed deposits that are seen as pure savings products likely to be held till they mature, and are paid interest at rates depending on their term. Broadly speaking, the longer the period for which the bank has a guarantee that it has access to the money deposited, the higher would be the interest rate paid to the depositor. For some time now, banks have had the freedom to set the interest rates they offer depositors on term deposits.

Saving bank deposits, from which depositors are substantially free to withdraw their money, are seen as being partly held for transaction purposes and partly for saving purposes. This makes them eligible for an interest rate that is lower than that offered on term deposits. In India’s post-Independence financial regulatory framework, the Reserve Bank of India had imposed a flexible cap on interest rates on all deposits. However, while interest rates on fixed deposits were fully deregulated in 1997, the interest rate on savings deposits has remained under RBI control. That rate had remained at 3.5 per cent from March 2003 till April this year, when it was raised to 4 per cent.

Regulation of deposit interest rates is by no means specific to India, but has been adopted in the past in most countries, and continues to prevail in many countries including China. In the US, interest rate controls under Regulation Q were introduced as part of the framework instituted by the Glass-Steagall Act in 1933, and were in place till the mid-1980s. The original intent of such regulation was to dampen price competition between banks. If interest rates are free to be set by banks, they would compete with each other to attract deposits by raising interest rates. One difficulty banks face is that while a substantial part of their resources come in the form of deposits that can be withdrawn more or less at will, they have to lend on terms that include a fixed maturity, which is inevitably longer than the average maturity of deposits..

If competition between banks to attract deposits raises the cost of funds, while banks are locked into loans charging interest rates that are not changeable till maturity, the interest rate spread gets squeezed leading to lower profits or losses. Since savings deposits are seen as partly savings products and not just maintained for transaction purposes, banks tend to treat these as part of their core deposits, which determines how much they lend. Based on the average monthly minimum balance maintained on savings deposits, the RBI too identifies 90 per cent of savings bank deposits as “core” deposits. This implies the banks can lend relatively long against such deposits, increasing the probability of an interest-rate mismatch if deposit rates rise sharply due to competition. This would result in a situation where banks suffer losses, turn fragile and face closure. This is in part what happened to the thrift institutions that went bankrupt during the Savings and Loan Crisis of the 1980s in the US, after US interest rates were deregulated. It is to prevent such outcomes, leading to a systemic crisis in the banking system that savings banks deposit interest rates were regulated in many contexts, including India.

But this was not the only danger. Even if banks don’t face a profit squeeze, the rising cost of capital as a result of competition between banks to attract deposits, would force banks to find investment and lending avenues that offer higher rates of return. Higher returns are inevitably associated with higher risks. If banks are not allowed to diversify into these areas, the demand to remove such barriers is bound to increase, forcing a liberalisation of banking policy. In that event, a consequence of the deregulation of interest rates could be an increase in the exposure of banks to “sensitive” sectors like real estate and the stock market. This could in turn lead to a speculative spiral, as was experienced in many countries including Japan in the late 1980s. The resulting increase in exposure to risk could render banks fragile, lead to defaults and losses and push them to bankruptcy. This was another reason why interest rate regulation was favoured.

Finally, as the US experience shows, increased exposure to risk can encourage securitisation to transfer and distribute that risk, while interest rate volatility (post-liberalisation) could increase demand for derivatives created in the first instance to hedge against risk. The resulting spurt of “financial innovation” can proliferate new risky products, aggravating the speculative frenzy, as happened in the run up to the 2008 financial crisis.

It could be argued that these issues are not of much relevance since savings deposits are only one form (and not the dominant form) in which households invest their savings. Since interest rates on term deposits are already free, the effect of liberalisation of rates on savings deposits are expected to be marginal and manageable. This, however, is not all true. The access to cash or liquidity that savings deposits offer to depositors, have made them an important means of holding savings for households. The household sector accounts for close to 85 per cent of all savings deposits in India’s banks, and these deposits account for about 13 per cent of the savings in financial assets of households. This compares with a total of 55 per cent of household savings in financial assets held as deposits with the banking system. Term deposits because of the higher return they offer since funds are the more popular. But 13 per cent of household savings is not a small amount. Given the substantial contribution of the household sector to aggregate savings, even this proportion makes savings deposits are an important source of funds for banks, amounting to 22 per cent of all bank deposits.

As noted earlier, banks treat a substantial proportion of these deposits as “core” deposits, lending relatively long based on them. In 2009, 57 per cent of the advances of scheduled commercial banks as a group were in the form of term loans. The figure in the case of domestic private sector banks went up to as much as 69 per cent. If the average cost of funds available to these banks rises, their profits could take a hit since they are substantially tied into long term lending contracts, As a corollary, over time, as banks adjust their portfolios, they would be unwilling to lend long, affecting one source of longer term finance. Their search for better returns would also increase the pressure to avoid lending to sections that must be reached as part of financial inclusion and to the priority sectors of the economy.

These consequences can be more intense in India because of the dominance of public sector banks, which hold 75 per cent of the assets of the banking system. Because of historical reasons and the confidence that public ownership induces, the public sector banks account for 93 per cent of savings deposits in India. About 52-56 per cent of the advances of public sector banks are long-term loans, and because of government compulsion their exposure to areas with long maturities like infrastructure and to priority areas and neglected sections tends to be substantial.

A likely outcome of interest rate liberalisation would be a decline of the share of public banks in savings deposits. In order to wean depositors away from public banks, in the aftermath of interest rate liberalisation, private banks may hike interest rates on savings deposits, so as to increase their presence in the domestic market. Public sector banks would be forced to follow or lose a part of their business or both. This could damage the profitability of the public banks, which even now bear a disproportionate share of the social obligations imposed on the banking system. Further, they would be forced into finding ways of reducing their commitment to financial inclusion. In sum, the likelihood is that the liberalisation of savings deposit rates would weaken the public banking system and be adverse from the points of view of growth, of financial inclusion and of stability.

Judged by timing, India’s central bank is among the world’s laggards when it comes to financial deregulation and liberalisation. It has, for example, not opted for full capital account convertibility, despite having worked out a road map a decade and a half back. The crisis in East Asia and Latin America brought home the dangers of that move, weakening those advocating a quick transition to full convertibility. Its decision to retain some controls on interest rates was another example of this tendency to dawdle. To India’s benefit this characteristic was read as a sign of its intelligence and independence, when the 2008 crisis showed that measures such as these tend to generate the fragility that triggered the meltdown. But this has not made a difference to those advocating these measures in the domestic context. Indian policy makers have chosen to breach the last dyke defending the banking system. India is indeed a late follower. But it is also a poor learner.