The Hindu Business Line : The deposit free lunch

Count your blessings if you are a cash rich corporate. For, a bank deposit rate war is on. It has been around from late 2006 and is, of course, nothing new. The last quarter of every financial year sees banks, especially of the public sector variety, on a frenzied drive to increase deposits, never mind the cost. The Government (as owners of banks) and RBI consider deposit growth (unfortunately) one of the prime indicators of good performance. It made sense in the early days of nationalisation when the country as a whole was much less banked but has lost meaning today.

Not that the Finance Minister does not know this. He did discourage Government banks from offering unviable interest rates for wholesale deposits. But they seem to have paid no more than lip service to his exhortation - such was the pressure to achieve targets.

Rate war

In recent times, the rate war has originated from aggressive new generation private sector banks. The competition is for large deposits of a crore of rupees or more from corporates. Most large companies, both in the private and public sectors, are cash-rich, thanks to booming sales and profits and capital-raising in India and abroad and are naturally eager to take advantage of the high, risk-free interest rates on offer.

And they are nothing to scoff at, being in double digits. In fact, there is a clear spread of 3 per cent or so between them and yields on T-bills and Government of India securities. What is more, the latter are prone to market risk and could be less liquid.

It seems to be another of the numerous free lunches on offer in the Indian economy and financial markets. Bank risk is equal to sovereign risk, because everyone knows no Government bank will be allowed to go under nor (and this is more important) any private sector bank. Thus, the deposit rate premiums on sovereign paper are available for zero incremental risk, as the market is sure the Government and RBI will do away not only with systemic risk (which, it can be argued, is their job) but also specific bank risk, if it comes to the crunch. After all, history is replete with instances of ill-fated private banks being rescued, the latest examples being Global Trust and Nedungadi.

PSBs are losers

The losers, clearly, are public sector banks, which have been forced to increase their deposit rates to match those of private banks (which started the rate war in the first place) but are unable to originate assets (loans) at yields which cover the higher deposit costs, (interest-free) CRR, SLR and credit risk, like private banks with their portfolio of personal, business, auto and credit card loans - essentially retail assets, marketed through a wide network of marketing and selling agents.

Obviously, there are both a `moral hazard' (`even if the worst happens, I am sure I will be saved'), which encourages more risk-taking and `adverse selection' (the search for yield dilutes credit standards) problems present in the situation.

We must ensure deregulated and free financial markets do not distort the interest rate - risk matrix and efficient resource allocation and enable a few to game the system.

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