The Hindu Business Line : What, floating rate deposits?

THESE are tough times for retail investors. They borrow at floating rates, but invest at a fixed rate, and are therefore exposed to high interest rate risk. Since retail investors cannot hedge their interest rate risk, investing in floating-rate products appears to be the only alternative to lower this asset-liability mismatch. But banks are unlikely to offer such products, as that would lower their spreads. There is merit in mandating that commercial banks offer floating rates on deposits along with fixed rates. Here is why.

Asset-liability mismatch: Housing loan typically figures as the single largest component of an individual's liability. And for most middle-income earners, fixed deposits are the major investment. This naturally leads to the asset-liability mismatch, because housing loans are floaters while deposits are not.

If interest rates were to move up, an individual would have to pay more on the housing loan because the benchmark rate would have moved up too. The interest earned on the fixed deposits would, however, remain unchanged. This leads to negative cash flows for the individual. This is because of the difference in the interest rate sensitivity of the asset-liability portfolio. This difference in sensitivity can be lowered if the individual is able to partially immunise his asset-liability portfolio.

Immunisation: If banks were to offer floating rate deposits, individuals can partially immunise their asset-liability portfolio. An individual may have taken a housing loan for Rs 25 lakh at, say, the 10-year government bond yield plus one per cent with a six-month reset. The same individual may choose to invest Rs 5 lakh in a 10-year floating-rate deposit with or without the same reset and benchmark. When interest rate increases, the outflow on the housing loan will be higher, but so will the inflow from the floating rate deposit.

But why should banks offer floating rate loans? After all, they make a handsome spread by lending at a floating rate and borrowing at a fixed rate. The reason is that offering floating-rate deposits may also improve their asset-liability maturity gap. If banks continue to push individuals to borrow at a floating rate and invest at a fixed rate, the savvy ones will move to short-term deposits, if they perceive interest rates moving up. The reason is that short-term deposits carry low reinvestment risk. That is, retail investors can easily switch to higher interest bearing deposits should interest rate increase in the future.

When more individuals move to short-term deposits, banks' asset-liability maturity gap will widen. This is because banks would have lent money for the long-term, but borrowed for the short-term. If interest rate moves up, banks' borrowing cost will also increase. Of course, if their assets earn floating rate, the asset-liability maturity gap may not necessarily result in negative cash flows. But it would certainly mean lower spreads.

Then, there is the cost of maintaining deposits. Employee time could be better served in core banking operations such as lending than on continual renewal of short-term fixed deposits. There is also a secondary positive effect of offering floating rate deposits. Typically, interest rates on fixed deposit rate will be higher than the floating rate deposit, as the former bears higher interest rate risk. Professional money managers can extract the banks' perception of interest rate movements by modelling a cross-section of the rate differentials.

Benchmark: The important issue is the benchmark rate for floaters. Our market is yet to develop a benchmark such as the LIBOR (London Inter Bank Offered Rate). The issue is not to construct a perfect benchmark, but to allow retail investors to partially immunise their asset-liability portfolio.

To start with, banks could use the six-month average government bond yield of comparable maturity. A five-year deposit would thus have the six-month average of the five-year bond yield as a benchmark. Other benchmarks such as the Prime Lending Rate (PLR) and the Bank Rate may not be a good benchmark because these rates lag the market rate, and do not often change to make a periodic reset for floaters meaningful.

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