Banks are not paying any interest on balances in current accounts. This has not only deprived banks deposits at cheaper rates but has also resulted in money from current accounts flowing into other markets and mutual funds

The chairman of State Bank of India (SBI), the largest commercial bank in the country, stirred up a hornet’s nest last month by suggesting that banks be allowed to pay interest of at least 2% on current account balances, on which no interest is paid at present. The Reserve Bank of India (RBI) has banned payment of any interest on current account balances since a long time to serve as a cushion for banks to meet the operational costs involved in maintaining these heavily operated accounts held mainly by businesses, traders and industries that have been using the services of banks for all their business needs liberally and free of cost.
 

Last year the RBI liberated savings bank accounts from the regulated interest rate regime and gave freedom to banks to fix their own interest rates on savings accounts. But it is a separate matter that no public sector bank has come forward to offer interest higher than the 4% p.a. fixed during the regulated regime, though a few small private sector banks are offering interest up to 7% p.a. on savings bank accounts.
 

But is there a case for paying interest on current accounts, which are mainly used for business transactions and not for saving purposes
 

Why is SBI asking for liberating current accounts from the regulated regime?
 

Now the only last bastion that remains to be liberated from the regulated interest rate regime is current accounts. And the SBI chief wants this to be deregulated along with the freedom to accept term deposits for periods as low as three days, as RBI permits acceptance of deposits for a minimum of seven days at present. The reasons for such a demand appear to be on the following grounds:
 

1. As the banks do not pay any interest on current account balances, corporates who have temporary surplus funds are tempted to divert such funds to other avenues of liquid investments available in the market.
 

2. Besides, as banks are not allowed to accept term deposits for less than seven days, corporates are not able use the banks for investing their surplus funds for short periods, say less than seven days, and therefore, look for alternative investment avenues, depriving the banks the benefit of such float funds.  
 

3. These surplus funds of corporates, therefore, find their way into the liquid schemes of mutual funds that offer redemption in 24 hours, which is as good as on demand, a facility is not available with banks at present.
 

4. As at the end of February 2013, as per press reports, mutual funds had Rs2,04,398 crore of assets under management (AUM) under liquid schemes and money market schemes of mutual funds and a large part of these funds would have originated from corporates, who would have normally retained such funds with their respective banks, if banks had offered some returns to them on these surplus funds.
 

5. But the irony is that these funds diverted from banks and held by mutual funds come back into the coffers of banks through the medium of call money market, as mutual funds are allowed to lend their surplus cash to banks through what is called as “overnight call money” at the ruling rate of interest. The overnight call money rate at which needy banks borrow from the market, where predominant lenders are banks and mutual funds, was as high as 17 % p.a. during the last week of March 2013, though the average call rate ranged from 7% to 8% during major part of last year.
 

6. If any bank is a regular borrower in the call money market, it is cheaper for the bank to give some interest on current account balances of their customers and retain those funds, instead of borrowing from the call money market at much higher rates, as call money rates depend on the liquidity available in the market  
 

In short, what it means is that by banning the payment of interest on current account balances and restricting acceptance of deposits by banks for a minimum period of seven days, banks have lost by way of flight of deposits from the banking system into other markets and mutual funds, which might have benefitted at the cost of banks. The banks say that this is one of the main reasons for the slowdown in deposit growth during the current year affecting the ability of banks to meet the increased demand for credit, which is growing at a faster pace than deposits.
 

What portion of bank deposits is held in current accounts?
 

As per the latest data published by the RBI, the following is the break up of deposits of scheduled commercial banks (SCBs) as on 31 March 2011.

Deposits of SCBs according to type of deposits as on 31 March 2011
 

Amount: Rupees crore

Figures in brackets are percentage to the total deposits     

Impact on the profitability of banks if interest is paid on current accounts
 

It is observed from the above table that current accounts constituted Rs6,70,126 crore which was 12.4 % of the total deposits as on 31 March 2011. Normally, in the banking industry, average deposits for the whole year constitute around 90% of the year end figures. So if we consider the average current deposits of all banks were approximately Rs6 lakh crore for the year 2010-11, and if interest at 2 % was paid on this amount, the total additional interest outgo for the banking sector would have been around Rs12,000 crore for the whole year. However, by deploying fresh funds attracted through current account balances, banks would earn additional interest on these funds, which would not only offset the additional interest outgo, but bring in additional interest income to banks, particularly to those who are active in the overnight call money market and those who are able to expand their credit portfolio profitably. In the normal course, there should not be any adverse impact on the banks’ profitability, if banks are able to raise additional funds through payment of interest and these funds are gainfully deployed through lending operations or otherwise. But in actual practice, the real impact will be different for different banks, depending upon the efficiency with which they deploy their surplus funds instead of keeping them idle in their tills or with the RBI.
 

Another revealing factor from the above table is that foreign banks have bulk of their deposits in current accounts, as 30.3% of their total deposits constituted current accounts, which were available to them virtually free of cost. And this accounts for their much higher profitability ratios, compared to domestic banks. This is again due to the debt-free status of most of the multinational companies which bank mostly with foreign banks and retain the surplus funds with them. The impact on profitability of foreign banks, if interest is paid on current accounts will, therefore, be definitely different, and cannot be equated with domestic banks.
 

Will payment of interest on current accounts de-stabilize banks?
 

There are views aired in the media that allowing banks to pay interest on current account might result in bloating the demand deposits of banks. This in turn may result in mismatch in their asset-liability position which can have a de-stabilising effect on the banks that are heavily dependent on current account balances, which are payable on demand. Theoretically, this may appear plausible, but in actual practice there are a number of checks and balances within which banks are required to operate and RBI keeps an eagle eye on the banks’ operations, keeping the bankers on their toes to ensure that there is no imbalance in their asset-liability position.
 

Besides, at present banks in India are required to keep 4% and 23% of their total deposits as cash reserve ratio and statutory liquidity ratio respectively, which banks may feel will help to serve as a stabilizing factor to some extent for the banking institutions in our country. However, there are bound to be differing views in this matter, as composition of deposits differs from bank to bank, and banks are vying with each other to get a slice of this cake of current accounts, which are considered as a part of the low-cost deposits for the banks.
 

What is the way forward?
 

The RBI has been keeping a steady silence on this matter so far. Coming as it does from the premier bank of our country; it is preferable to see whether it could be a win-win situation for both the banks and its customers. And if it helps to improve the profitability of banks without sacrificing their stability, it certainly requires to be debated with the seriousness it deserves. In the context of the slow growth of deposits in the banking system during the year just gone by, with a view to assess its impact on the profitability of banking industry, the RBI may consider the pros and cons of de-regulating the interest rates on current accounts by making a thorough analysis of the proposal in consultation with all the stake holders and take a pragmatic view in the interest of developing the banking institutions of our country on sound lines.  
 

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(The author is a banking analyst and he writes for Moneylife under the pen-name ‘Gurpur’)