How do banks set Fixed Deposit Interest Rates?
Hi!
Let’s be clear from the start - I am not an expert in Banking systems. I could talk to experts in Banking, but I don’t have access to them. All I can do is some Googling and trying to understand some basics.
Hence, this is going to be a massive oversimplification - mostly because I don’t understand the nitty-gritty details myself. I just thought it would be interesting to scratch the surface and share what I found.
With that out of the way, let’s move on.
Some Banking jargon
1. Net Demand and Time Liabilities (NDTL)
Like any other company, banks have their own assets and liabilities.
Bank Assets
Bank assets include loans provided to the individual borrowers or companies, loans to other banks, etc.
The bank generates income through these loans, so they are assets.
Bank Liabilities
Demand liabilities
Demand liabilities are all liabilities which the bank needs to repay on demand. They include current deposits, savings bank deposits, demand drafts, etc.
Time liabilities
Time liabilities are liabilities other than demand liabilities. Some examples are fixed deposits, recurring deposits, gold deposits, etc.
Bank liabilities need to be repaid to its lenders, so they are liabilities.
Computing NDTL
On a high level, NDTL is computed as:
NDTL = (demand liabilities + time liabilities) - bank assets2. Cash Reserve Ratio (CRR)
Cash Reserve Ratio is the percentage of NDTL value that needs to be kept as cash deposits with the RBI. RBI does not pay interest to the bank on this deposit.
The CRR as of Sept 26th, 2022 is 4.50%. [2]
CRR provides banks with a floor amount of cash they need to keep to fulfill any liabilities such as fund withdrawals,
3. Statutory Liquidity Ratio (SLR)
Statutory Liquidity Ratio is the percentage of NDTL value that needs to be maintained as investments in certain specified assets, such as:
Cash
Gold
Treasury Bills of Govt. of India
State Development Loans of State Govts. of India.
The SLR value should be between 18% and 40% [2]
SLR is primarily used to direct bank funds to the government, and in turn, the economy. These funds are usually low cost due to the relatively low interest rate for Treasury Bills and State Development Loans. [3]
4. Repo rate
In case a bank has a temporary liquidity issue, it can borrow funds from the RBI. It sells its Govt. bonds to the RBI, and agrees to re-purchase these bonds at a fixed price on a future date. The re-purchase price is usually higher.
This rate of interest is the re-possession rate or repo rate.
The repo rate as of Sept 26th, 2022 is 5.40%.
So why borrow from public?
In an ideal scenario, whatever funds a bank has, it lends that out for max gainzz. But due to the restrictions about it can’t.
CRR is kept with the RBI without interest → can’t be used for lending activity
SLR is used to purchase govt bonds → can’t be used for lending activity
All in all, the banks has about 77% of its funds to lend out.
If the bank wants more funds for those gainzz, it can also borrow from the RBI at a rate lower than our FD rates. But it can’t use all of the 77% because it doesn’t usually use all its remaining money to buy Govt. bonds. It can make more money lending money to regular folks like you and me.
Since it doesn’t hold so many Govt. bonds, it can only borrow so much from the RBI.
Enter → regular folks like you and me. Banks can borrow from us using the Fixed Deposit instrument. They give us interest, and then lend the money out for a higher interest.
Factors affecting FD interest rates
1. CRR
If CRR increases, banks need to keep more money with the RBI. This decreases the available cash for lending, and increases FD interest rates as banks need to maintain or improve their liquidity.
2. SLR
If SLR increases, banks will need to buy only pre-approved investments, which restricts their lending activity due to lack of funds.
3. Repo rate
If the repo rate increases, it is more costly to borrow from RBI. To lure the public, banks might increase
4. Existing liquidity in market
If the market has a high liquidity, the bank may skip increasing FD rates and borrow using short term bonds from the open market itself.
Wrapping up
I was curious about how banks actually price their FD interest rates while I was writing my previous post on Fixed Deposits. This was something new I tried out, so please let me know your feedback in the comments!
References
[1] https://rbi.org.in/scripts/BS_CircularIndexDisplay.aspx?Id=12313
[2] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=12131
[3] https://www.adb.org/sites/default/files/publication/152596/south-asia-wp-031.pdf
General References
https://www.rbi.org.in/Scripts/BS_ViewMasterCirculars.aspx?Id=2377&Mode=0