What is a Certificate of Deposit (CD)?
A Certificate of Deposit (CD) is a financial product offered by banks , where the investor deposits a lump sum amount for a fixed period at a pre-negotiated interest rate. It is generally considered a low-risk investment. At the end of the term, the investor receives the amount deposited plus the accrued interest.
Current Scenario
In the period between April and August 2023, banks, predominantly public sector banks, have been increasingly issuing CDs to meet the growing credit demand, which has surpassed deposit growth. The data from Prime Database illustrates that CD issuances have escalated to ₹2.62 trillion, compared to ₹2.5 trillion in the same timeframe last year. The CD market saw fluctuations with a notable increase in August 2023, partly due to the RBI's directive for banks to uphold an additional Cash Reserve Ratio (CRR) of 10% of their Net Demand and Time Liabilities (NDTL).
Interest Rates
One-year bulk deposits: 7.6%
One-year term deposit rate: 7.25%
Three-month CD rate: 7.05%
Why Banks are Resorting to CDs Now
Cost-Efficiency: CDs offer a more affordable avenue for raising funds compared to other financial instruments. Banks are leveraging CDs to diminish costs strategically.
RBI's Mandate: The RBI's mandate to maintain a higher CRR has squeezed liquidity, encouraging banks to turn to CDs to augment their liquidity position.
Stabilized Rates: Unlike the previous year when the RBI was frequently hiking rates, making CDs expensive, the rates have now stabilized, presenting a favorable environment for banks to raise funds through CDs.
Festive Season and Tax Outflows: The upcoming festive season and impending tax outflows are expected to maintain the trend of increased CD issuances.
Liquidity Management: Given the oscillating liquidity conditions, CDs remain a vital tool for commercial banks to manage liquidity efficiently.
Bank Participation
Public Sector Banks: Accounted for over 65% of all CD issues during this period, with a 30% year-on-year increase. Notable participants include Canara Bank, Punjab National Bank, Bank of Baroda, and Indian Bank.
Private Sector Banks: Contributed to 26% of CD issues, a decrease of 25% year-on-year. Axis Bank and IDFC First Bank were the primary issuers in the private sector.
The Question Arises:
Why can't banks hike deposit rates instead of going for CDs?
Answer:
Banks might opt not to increase deposit rates and instead resort to issuing Certificates of Deposit (CDs) for a variety of strategic reasons, including:
Cost Management
Increasing deposit rates would mean higher interest payments to all depositors, escalating the banks' operational costs significantly. CDs allow banks to have a firm grip on the amount they are raising and the interest rate they are willing to offer, facilitating better cost management.
Maintaining Profit Margins
Banks generate revenue through the interest spread, which is the difference between the interest earned on loans and the interest paid on deposits. By refraining from increasing deposit rates, they can maintain a healthy interest spread, safeguarding their profit margins.
Liquidity Management
CDs grant banks the flexibility to manage their liquidity more adeptly. They can issue CDs with diverse maturities based on their liquidity needs, a strategy not applicable with general deposits.
Market Dynamics and Competition
The deposit interest rates are often influenced by broader market dynamics and competition amongst banks. Avoiding a rate war with other banks by not hiking deposit rates can prevent an unsustainable upward spiral in the market.
Regulatory Requirements
Banks are mandated to adhere to several regulatory prerequisites, including maintaining a certain level of Cash Reserve Ratio (CRR) with the central bank. CDs can be structured to help banks meet these regulatory requirements more efficiently compared to hiking deposit rates.
Attracting Large Investors
CDs can be targeted at large investors and institutions seeking short-term investment avenues with higher returns compared to regular deposits, helping banks to attract a different set of investors.
Control Over Tenure
CDs afford banks the leverage to control the tenure of the deposit, aiding in the effective management of asset-liability mismatches. They can tailor CDs for specific tenures based on their funding necessities.
Quick Fund Raising
CDs are a viable tool for banks to amass funds swiftly to address any immediate liquidity concerns, a strategy not possible with a gradual increase in deposit rates.
Customer Behavior
Banks also factor in customer behavior and preferences. A sudden surge in deposit rates may not instantaneously result in augmented deposits as customers might take time to adapt to the altered rates.
Conclusion
While the option to hike deposit rates remains on the table, it comes with its own set of challenges and implications. CDs offer a more flexible and targeted approach to raising funds and managing liquidity for banks, presenting a strategic advantage in the current economic landscape.
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