Some banks in India will be raising rates on term deposits in order to mobilize savings and meet rising demand for credit. In the August 8th issue of Financial Express economists Ram Tamara and Madhuri Saripelle of Nathan India explore what could happen if interest rates on savings accounts were deregulated and allowed to go up or down from the current rate of 3.5 percent.

Tamara and Saripelle note that a rate increase for senior citizens in India reduced their consumption of non-essentials by 12 percent, showing that households shift from consumption to savings when rates rise. If savings account rates are deregulated in India and rates rise people might put more in savings accounts, not only by spending less but also by moving excess funds from less liquid or more costly financial instruments into bank savings accounts.

Raising interest rates, however, raises a bank?s cost of acquiring funds and erodes profit unless costs are passed on to borrowers. Banks could devise accounts that allow them to compete for deposits while lowering the weighted average cost of mobilizing funds. For example, they could pay rates lower than 3.5 percent on deposits insensitive to interest changes while paying more than 3.5 percent on sensitive deposits. Such innovations require a good understanding of customers? savings behavior.

Seniors in India have saved more when rates rise, but this might not hold true for 25-35 year olds, who are new in the work force, spend more, and are less risk averse. For people 35-55 family commitments take precedence. Their savings portfolios may be diverse but they are more likely to respond positively to changes in interest rates than younger people because they value liquidity, stability, and safety. Even though most deposits in commercial banks are in urban areas, urban households have only 46 percent of their savings in banks while rural households have 86 percent. The young, urban middle-class consume the most and account for the bulk of retail credit. In fact, they spend 25 percent of their income on EMIs on loans and credit cards. Rural households, lacking access to credit and even awareness of other financial instruments, are less likely to respond to changes in interest rates. But as the spread between borrowing rates and savings account rates narrows, the urban middle class would likely begin saving more.

In the July 17 issue of Financial Express, Tamara and Saripelle explored how savings behavior was slowing the growth of bank deposits and examined the superior performance of private banks in attracting deposits and suggested that deregulating interest paid on savings accounts would help banks compete for deposits and mobilize savings.

A national business daily, Financial Express is part of the Indian Express group, one of the oldest newspapers in India.