Your Money- Floating rate FD: Is it a good idea?

With interest rates climbing up, floating rate fixed deposits appear to provide the possibility of higher returns. But there’s more to the story

Next to gold, fixed deposits (FDs) are the favourites of investors across India. Safety of investment and predictability of income are two reasons that have endeared FDs to investors. However, FD interest rates have remained muted over the past few years. In the context of interest rates climbing, floating rate FDs appear to provide the possibility of higher returns along with safety and predictability. However, this needs to be analysed in the backdrop of the drivers of deposit rates.

What drives movement of deposit rates?
Movements in key interest rates in the economy are one of the prime drivers of lending rates, and to a lesser extent, deposit rates. The repo rate – the rate at which the Reserve Bank of India (RBI) lends to all banks – is one of the key interest rates in the Indian economy. The RBI resorts to cuts in the repo rate when there is a need to spur economic activity, and raises the repo rate when inflation threatens to spiral upwards beyond its comfort levels.

Typically, transmission of repo rate movement to lending rates is quicker and higher than that to deposit rates. This is because each bank will attempt to keep its lending rate as high as possible and its deposit rates as low as possible in order to increase its Net Interest Margin (NIM). The second driver for movement of deposit rates at any bank is the Credit-Deposit (C-D) Ratio of the bank. It is the ratio of total bank credit to its aggregate deposits.

If this ratio is low, it means the bank has more room to lend and lesser room to accept deposits, which in turn may keep both its lending and deposit rates on the lower side. The third driver is the extent to which a bank’s loans are linked to repo rate. The higher this percentage in a rising interest rate scenario, the more room it has to allow its deposit rates to rise while still protecting its profitability.

Trends in key interest rates and inflation
Due to global supply shocks, inflation has remained above target levels for the past six months and well above the RBI’s comfort zone of 6%. In its latest announcement, the RBI has retained its inflation projection at 6.7% for this year, and has indicated that inflation may be nearing its peak. The RBI has increased the repo rate thrice in the last three months, raising it by 1.4%. With this frontloading of monetary policy action bringing the repo rate to 5.4%, the central bank has expressed confidence in reining in inflation.

Can floating rate FDs help in the current situation?
Lending and deposit rates may continue to grow in line with repo rate increases, albeit not keeping pace with the repo rate. C-D ratios of banks have dropped from around 78% in March 2019 to around 72% in March 2022. Saddled with lower C-D ratios, most banks are trying to grow their loan books and feel demand for loans may not reduce. Coupled with competitive pressure, there may thus be a less-than-normal increase in lending rates, and hence, in deposit rates too.

Also, as per an RBI report of March this year, foreign banks have around 74% of their loans linked to repo rate while private banks have around 61% linked, so they are more likely to have higher increases in their deposit rates than public sector banks, which have only around 33% linked. Thus, floating rate FDs may help in the current situation, but to a limited extent. Investors can wait out the global supply shocks to recede and shop for competitive deposit rates from banks with higher C-D ratios and lending rate linkage to repo rate.

This article was originally published in The Financial Express