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RBI to Banks: Rollover Fixed Deposits Without Penalties

The Reserve Bank of India has told banks that if customers want to pre-close a deposit and take on a new deposit at the same bank, then the bank is not allowed to levy a penalty in the form of lower interest. (Notification)

Conversion of term deposits, daily deposits or
recurring deposits for reinvestment in term deposits

Please refer to paragraph 104 of the Monetary Policy Statement 2010-11 announced by Governor on April 20, 2010 (extract enclosed).

2. In terms of  extant guidelines,  as stipulated at paragraph 2.12 of the Master Circular dated July 1, 2009 on ‘Interest Rates on Rupee Deposits held in Domestic, Ordinary Non-Resident (NRO) and Non-Resident (External) (NRE) Accounts’, banks should allow conversion of term deposits, daily deposits or recurring deposits to enable depositors to immediately reinvest the amount lying in the aforesaid deposits with the same bank in another term deposit. Banks are required to pay interest in respect of such term deposits without reducing the interest by way of penalty, provided that the deposit remains with the bank after reinvestment for a period longer than the remaining period of the original contract.

3. On a review of the extant regulatory norms,  and in order to facilitate better asset-liability management (ALM), it has been decided to permit banks to formulate their own policies towards conversion of deposits with immediate effect.

For those of you who find this confusing: Let’s say you had a 1 year fixed deposit (FD) at a bank, at say 7%. The bank raises rates two months after you start the deposit, to 8%. You’re now stuck with an FD yielding 7% while everyone else gets 8%, so you’re thinking, “Why not close the FD, and take on a new FD at the new rate?”.

Answer: Because banks have a policy that if you “pre-close” a fixed deposit, you don’t get the contracted interest rate for the two months; what you get is a complex calculation – usually the lower of a) the two month interest rate when you started the FD and b) the two month interest rate now. That might by, say, 4%. Meaning for you the evaluation is between:

a) Keeping the current FD at 7%

b) Closing current FD, getting 4% for two months, and then 8% for another year.

Such calculations are usually not complex; but no one has the time to do such mathematics, especially when there is an unknown component (what will the interest rate be after one year etc.). This is especially silly because the bank should have NO problem renewing the FD, since the money is going to be with them for another year, so they don’t even have to do any complicated transactions to “unwind” the current deposit and give you a new one.

Typically, banks charge the interest penalty because now they have to get funds back from the market that they had invested for a longer term and that involves a cost. But if you keep the funds back in the same bank, they don’t need to do such transactions.

What this announcement does is: gives customers the full interest for the period of the FD till now, and the new FD rate going forward. No penalties for early withdrawal. While this is very positive for customers, it’s not all that great for banks who have traditionally used this scheme to MAKE money during interest rate hikes (which is what is happening right now). But anything that’s good for the customers is worthy of applause. Bankers should have done this themselves, but nowadays they are largely scum. Okay, I exaggerate; but bankers will usually not flinch when using such penalties to steal your money – look for instance at pre-closure charges for loans, or processing fees. Some of which are being waived off by certain banks, bless them.

Increasingly banks are getting regulated out of their traditional income sources – the savings bank interest con-job where they have to pay mandated rates for the whole month, and pre-closure FD penalties. Soon, RBI is likely to ban pre-closure fees for loans as well. They’ll have to earn money the boring traditional way by borrowing at lower and lending at higher, but where’s the fun in that?

  • Srikanth Meenakshi says:

    >Deepak,

    Maybe I'm wrong, but..

    //Typically, banks charge the interest penalty because now they have to get funds back from the market that they had invested for a longer term and that involves a cost. But if you keep the funds back in the same bank, they don’t need to do such transactions.//

    Suppose a bank collects 10K from a thousand investors promising 7% in one year. That is one crore rupees. The bank turns around and invests in a diverse debt portfolio of an year's duration yielding 8-9%. At the end of the year, the bank keeps about 1% and the investor gets 7%.

    Now, if the investor calls the deposit midstream in three months when the prevailing rate is 8%, where is the bank to get the money from? They will have to ensure that their debt instruments are callable as well. And this cascades, making borrowing more expensive in the end.

    This move by RBI might be retail investor friendly, and the sums of moneys here might not matter for large financial institutions. But in the large, I am not so sure of the impact to the debt market as a whole.

    Did I get this wrong?

    Srikanth

  • Deepak Shenoy says:

    >Srikant: You are right where there is a one to one match between terms (1 year FD money is used to buy one year debt)

    In reality banks borrow short and lend long (the asset liability mismatch is usually driven by term differences). So usually spreads are much much wider and longer term – so a year FD will be 7% which is lent out at 14% for say four-five years as a car loan or something. A tenure increase – which is what happens if an investor wants to mid-term rollover a deposit – is not just acceptable, it is desirable for the bank.

    Remember investors calling the deposit early to take the money out will still be charged a penalty. Only those that roll it over with the same bank are exempt.

    Most debt instruments from banks are callable btw. A bank can call any loan it likes, which is standard in most loan agreements (the only exception being certain home loans and certain corporate term loans). Everything else – credit lines, overdrafts, credit card debt, personal loans are all callable. No banks call for them because usually they have access to an RBI window for any short term cash flow, and because it will piss off customers. In a crisis situation RBI gives them short term loans to tide the time over.

  • Srikanth Meenakshi says:

    >Got it, makes sense….thanks for the explanation!!

    Srikanth

  • rajsmusings says:

    >Well. I'll be gladly look forward to day when there is no penalty on loan pre-closures.

    Right now pre closures charges are almost farcial. One ends up paying the same amount whether pre-closure or going through the whole term in case of personal loans.

  • aditya says:

    >Hi Deepak,

    Is this mandatory for banks yet ? I have been making rounds to capture the yields, and all the banks have been charging ( or at least mentioning) the 1% preclosure penalty.