With a slew of banks alluring customers with 6 to 7 per cent annual return – instead of the staid 3 to 4 per cent -- on savings account deposits, customers are confused if they should switch their savings account to these banks. Salil Dhawan of Investment-mantra suggests you shouldn't.

The Reserve Bank of India recently let banks decide whether or not to offer higher interest rates on savings account deposit.

Taking this cue many banks have started offering 6 to 7 per cent annual return on deposits to attract customers to move their money into these banks. The big question though, is, should you bite the bait?

Before we delve into the pros and cons of such a move it will be worthwhile to understand a few basic concepts first.

Courtesy: Investment-mantra.in

1. Savings account vs current account

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 savings account.

2. Why savings rate matter to banks?

As savings accounts constitute around 22 per cent of the total bank deposits, it provides a source of low-cost fund to banks. Even when the repo rate (the rate at which banks borrow from the RBI) was hovering around 8.25 per cent, the savings rate was fixed at 4 per cent before deregulation.

Most banks would want to maximise their CASA (Current account to savings account) ratio as it provides funds at low cost.

Before deregulation (freeing of interest rates) 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.

3. Asset liability mismatch

As all banks offered similar rate of interest before deregulation, there was no incentive for customers 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.

4. Savings rate can move down as well

When interest rates are deregulated, it could be on the downside as well. It can very well happen that at some point of time banks would not be in a position to compensate savers properly if there is not enough liquidity in the system.

This would impact small savers and pensioners who depend only on savings rate interest for their livelihood.

5. Unhealthy competition and systematic risk

Saving deposits offers low cost of funds and, hence is 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 banks which would ultimately be passed on to the borrower, leading to higher cost of borrowing.

6. Opportunity for small banks?

Banks such as Yes Bank, IndusInd Bank , Kotak Mahindra Bank see this as a big opportunity to lure more customers by offering attractive savings rates.

For instance, Yes Bank saw 30 per cent rise in savings deposit balances in the last two months. YES Bank again recently intensified the deposit rate war, increasing the interest rate on savings deposits for the second time in two months.

The private sector lender would now offer 7 per cent interest on savings deposits above Rs 100,000 to strengthen its low-cost deposit base. YES Bank was the first bank in the country to raise the savings deposit rate, after it was deregulated in late October.

The bank had increased the interest rate by 200 basis points to 6 per cent. The lender said it would continue to pay 6 per cent interest for deposits below Rs 100,000.

Last month, Karnataka Bank raised its savings deposit rate by 100 basis points to 5 per cent. Three other private sector banks, Kotak Mahindra Bank, IndusInd Bank and Ratnakar Bank, along with Saraswat Bank, had raised their savings deposit rates.

7. What big banks have to say about it?

Public sector banks, including the country's largest lender, State Bank of India, and large private lenders like ICICI Bank, HDFC Bank and Axis Bank have not raised their savings deposit rate, as according to them savings deposit accounts were typically used for transactional purposes.

Reality is that for large banks such as State Bank of India, which has the largest deposit base, a 100 bps increase in savings rate can potentially increase their annual interest expense (for the rest of the fiscal) by 4 to 5 per cent or Rs 1,400 to Rs 1,500 crore.

Even for private banks such as ICICI Bank Ltd and HDFC Bank with large deposit base, the effect on annual interest expense (for the rest of the fiscal) can potentially be between 3 per cent to 5 per cent increase.

8. What's in store for depositors?

Depositors can expect better interest rates than the existing rates. Deregulating will certainly increase competition between banks and it will benefit the depositors.

In addition, rural and semi-urban depositors who do not have much knowledge about fixed deposit and who have been actually losing money because of high inflation can benefit from it.

9. Should you switch?

Don't be perturbed when you see your bank offering a 150 to 200 bps lower return on your savings account. If you have to open a new account then don't take only the savings account rate into consideration, but look at the services it offers and charges.

Also, remember that a deregulated savings account rate means that if rates can be higher now they can potentially be lower in a different market environment. Just like fixed deposit rates move up and down depending on policy rate, the savings rate will also adjust.

The customers need to understand that banks that raise savings rate and incur additional costs are unlikely to absorb it and will pass it on to consumers. Banks paying higher rates may offer minimal benefits while low savings rate bank accounts might offer more benefits.

Customers need to keep an eye out for the need to maintain a higher minimum balance, higher charges for cheque books, 'outstation cheque' clearances, inter-bank transfers and so on.

It's unlikely that customers would switch banks anytime soon, purely on account of higher interest rate.

Moreover, if you have a salary account or your bank account gets debited every month towards your loan commitments or even for utility bills such as electricity or telephone bills, changing a bank account can get tedious.