Fixed Deposit Market – In need of prudent strategies

Dr N Balakumar

July 1996

Money is the key input for a finance company’s growth. Fixed deposits is one of the major sources of raising funds for a finance company. On the other hand, from the investor’s angle, fixed deposit is considered as an important investment opportunity, especially, in the income bracket of middle and upper-middle segment.

So far, all the non-banking finance companies (NBFCs) have been paying the same interest rate for deposits. Only way which product has made differenciation was by the amount of incentive paid to the investor. Further, the fixed deposit market was also driven by the image of the company. In short, the fixed deposit market was driven by the dual factors – image of the company and incentives. If the image of the company is very high, the incentive offered will be minimum. On the contrary, a company will give high incentives, if the company’s image is very poor.

Recently, the Reserve Bank of India (RBI) has freed interest rates on deposits and relaxed the norms for NBFCs, which fully comply with the guidelines. Further, RBI is also planning to amend the Act in the Parliament to bring all the unincorporated finance companies under its purview.

This major move by the RBI has been welcomed by all the NBFCs with joy. And the fixed deposit industry, which is driven by the image of the company and incentives, is thinking an interest rate in the band of 17 to 20 per cent.

By increasing the interest rates, the NBFCs are not going to incur additional cost for mobilizing funds (currently, NBFCs though offering only 15 per cent interest, their cost of funds range between 15 to 20 per cent due to the incentive component). Thus, without incurring any additional cost, NBFCs will gain higher mileage.

Obviously, if the NBFCs increase the interest rates, they will reduce the incentives or they may not entertain incentives at all.

The immediate sufferer of this will be the Commercial Banks, especially, in the urban and metros where most of the NBFCs have branches. In these regions, commercial bank’s deposits will drift to a great extent.

It has to be noted that the RBI has not allowed all NBFCs to play with the interest rates. Only those NBFCs which have registered with RBI having credit rating and who comply with prudential norms have been permitted to offer competitive interest rates.

Thus, those NBFCs who have not registered with the RBI will now have to register if they want to survive in the fixed deposit market (alarmingly, out of over 45,000 NBFCs, about 900 NBFCs are only registered – a meager 2 per cent). Also they have to seek for a credit rating. This will lead to a boom in the credit rating business.

If NBFCs offer a high rate of interest, then, fixed deposits as a root to mobilize funds for manufacturing companies will get blocked.

This move by the RBI will affect all the unincorporated finance companies and nidis, which offer great magical interest rates plus cash incentives plus a bumper prize.

At present, major portion of the fixed deposits comes through the route of brokers to the NBFCs. This trend may change over a period of time, if the NBFCs go in for direct marketing strategies. In such a situation, advertising agencies business with NBFCs will grow.

From the depositors’ point of view, so far they have been receiving 15 per cent interest, apart from cash incentives plus a gift (if any), which are not accounted. Now, if the rates are raised, their legal income will raise, thus, more taxable income for the investors.

If interest rate war erupts among NBFCs on various grounds like credit rating – higher the rating, lower the interest rate and vice versa; period of deposit, – higher the period of deposit, higher the interest rate and vice versa, etc. will confuse an average investor.

To add fuel to the fire, the communication platforms most of the NBFCs have taken – knowingly or unknowingly – almost sends alarming signals to the investors, since the messages from these communications resemble those of the Non-Banking Finance Firms (NBFFs) that have failed in the recent past, thanks to the interest rate war.

Today, the depositor has to choose not only between one NBFC and another, but between one instrument to another too. Thus, an investor has to identify investment strategies keeping safety in mind while maximizing his returns.

On what criteria an investor can choose? An immediate answer is credit rating. But, is it prudent to choose your NBFC based on credit rating for fixed deposits? The answer will be both ‘Yes’ and ‘No’. How and why?

Credit rating is only a one year phenomenon. Credit rating of a NBFC will be updated every year, implying that the rating of a finance company can increase or decrease year after year. If the rating is improved, no problem for the investor. On the other hand, if the rating is degraded, an investor who has made a two or more period deposit with that company (based on the credit rating confirmed at the time of deposit) will feel disgusted. This is a clear case where we see the credit rating firms in India being allowed to exist with no accountability.

Thus, a depositor should keep credit rating as the criteria to choose the finance company only for one year deposits. For two and more year deposits, depending on credit rating to choose the finance company may not be an intelligent investment decision. In such cases, the investor has to go in for his own analysis - has to see the company’s past performance, service offered, etc. However, how many average depositors are capable of analyzing finance companies prior to depositing their hard earned and saved monies with NBFCs is doubtful.

In sum, the need of the hour is prudent strategies, both for the borrowers as well as for the lenders of funds.