AN OVERVIEW OF BANKING

CHAPTER-IV

DEPOSIT PRODUCTS

This chapter mainly focuses on different kinds of deposits accepted by the banks and
interest rates offered by explaining the following in detail.

• Types of Bank Deposits accepted by banks.

• Interest Rates offered on different types of Deposits.
• Composition of Bank Deposits.

Introduction:

Deposits are the functional base upon which banks thrive and grow. The ability of a
bank’s management and staff to attract money from customers and businesses is an
important measure to gauge a bank’s acceptance by the public. Deposits are the basis for
bank loans and thus represent the ultimate source of bank profits and growth. These
generate cash reserves through which new loans are created. The management
effectiveness of a bank can be gauged by finding whether the deposits are raised at the
lowest possible cost and whether enough deposits are available to fund those loans the
bank proposes to make.

Deposits have typically lower interest costs than the other types of funds. Another
important feature of these deposits is their relative stability compared to hot money i.e.
the money raised from the money market etc. These two features of the deposits-stability
and low cost source of funds, make them more preferred source of funds by banks. All
things being equal, banks that have a greater base are more valuable than the banks with
poor deposit base.

Financial markets have turned into buyer’s markets. Banks are also changing with time
and are trying to become one-stop financial supermarkets. Market focus is shifting from
mass banking products to class banking with introduction of value added and customized.
Eventually the banks are planning to market bonds and debentures also. Banks selling
insurance has already become a reality, which was considered a distant dream some time
back.

With the introduction of Rupee floating rates for deposits as well as advances, products
like interest rate swaps and forward rate agreements for foreign exchange, risk
management products like forward contract, option contract, currency swap are offered
by almost every bank in the market.
Types of Deposits offered by Banks:
Deposits are accepted in different ways. Differentiation in deposit types may arise from
the type of customer who holds the deposit, tenure of the deposit, its nature and the
interest factor. Based on these parameters, the deposits can be broadly classified into two.
1. Transaction Deposits 2. Non - Transaction Deposits.

1. Transaction (Payments) Deposits

A deposit which facilitates the account holder to transact through a negotiable or
transferable instrument, cheque, a written order of withdrawal, a telephone order to
transfer funds, or other similar means of making payments and transferring monies to
third parties is known as a transaction account. These are one of the oldest deposit
services offered by banks where banks make payments on behalf of its customers.

This transaction or demand deposit service requires the bank to honor cheques and
withdrawals. Transaction deposits include regular non-interest bearing demand
deposits, which do not earn an explicit interest payment but provide the customer with
payment services, safe keeping of funds and record keeping for any transactions carried
out through cheques. They also include interest bearing demand deposits that provide
all of the foregoing services and pay interest to the depositor. Current account and
Savings account are the most widely used transaction accounts.

Non-interest bearing demand deposits

There are no interest payments on the current accounts. Payment of interest on checking
accounts has been prohibited with the passage of the Glass-Steagall Act in the US. These
demand deposits are among the most volatile and least predictable of a bank’s sources of
funds, with the shortest potential maturity as they can be withdrawn without notice. Most
non deposit bearing liabilities are held by business firms. Many of the individual account
holders have moved towards other types of deposits that pay interest.

Interest bearing demand deposits

In the early 1970s in New England, hybrid checking-savings accounts were introduced in
the form of Negotiable Order of Withdrawal (NOW accounts). NOWs are interest
bearing saving deposits that give the bank the right to insist on prior notice before the
customer withdraws funds. As the notice requirement is rarely exercised, the NOW can
be used like checking account. In US with the passage of the Depository Institutions
Deregulation Act, 1980, NOWs became a nationwide phenomenon.

In US, two other important interest bearing transaction accounts were created in 1982
with the passage of the Garn-St Germain Depository Institutions Act. Banks and non-
bank thrift institutions could offer deposits competitive with the share accounts offered
by money market funds that carried higher, unregulated interest rates and were backed by
a pool of high quality securities. The result was the appearance of Money Market Deposit
Accounts (MMDAs) and Super NOWs (SNOWs), offering flexible money market
interest rates but accessible via cheque or preauthorized draft to pay for goods and
services. MMDAs are interest-earning short maturity savings accounts with limited
transaction privileges. Banks pay interest rates enough to attract and hold the customers
deposit. The customer is usually restricted to limited transfers or withdrawals per month,
with no more than three transactions as cheques written against the account. The interest
rate paid on a money market account is usually higher than that of a regular passbook
savings rate. Money market accounts also have a minimum balance requirement.

2. Non-Transaction (Savings, or Thrift) Accounts

When the deposit account does not facilitate routine payments or transfer of funds for
other transaction purposes, it is a non-transaction account. These deposits are designed to
attract funds from customers who wish to set aside certain amount in anticipation of
future expenditures or financial emergencies. These deposits pay higher interest rates
compared to transaction deposits.

Based on this differentiation of a transaction and a non-transaction account, the deposits

mobilized by the Indian banks are generally classified into three namely A).Current
Account), B) Savings Bank Deposits and C). Term Deposits. A detailed discussion on
the features of these deposit accounts, the computation of interests etc. is given below:
Banks receive deposits through three types of basic accounts: demand deposits (also
known as a checking account or demand deposit account), savings deposits and fixed-
time deposits.

A). Current Account

The depositor can withdraw the money at any time (as long as the money is available in
the account) and also can order the bank to use the money to pay third parties, generally
through a cheque. Banks may or may not pay interest on these accounts. If they pay
interest, the account is called a “NOW” (negotiable order of withdrawal) account. It is
possible that banks may charge fees for demand deposit accounts, but in many cases
these fees can be reduced or avoided by maintaining a minimum balance or by satisfying
other criteria established by the bank.
As mentioned earlier, current accounts are transaction accounts and hence are offered to
business firms. Due to the ease the business firms have in depositing and withdrawing
funds from this account, it actually facilitates cash management for the firms. No advance
notice is required to withdraw the amount. It being an operating account, the customer
can easily withdraw funds from the current account using a cheque facility.

However, banks do require the account holder to maintain a certain amount of minimum
balance continuously. In some cases, depending on the credibility of the customer, the
bank may also allow the deposit holder to overdraw (OD) from the current account. As
the account enables easy liquidity, the deposit in this account does not earn any interest.
Although these accounts are non-interest bearing liabilities of the bank, they are not
expense free as they generate processing costs. To cover these costs, the banks usually
collect service charges related to account activity or account balances or both.
B) Savings Bank Account
The depositor usually plans to maintain the funds in the account for an extended period of
time. Banks pay interest on these accounts. Banks may also charge fees for savings
accounts, but in many cases these fees can be reduced or avoided by maintaining
minimum balances. Other than for business purpose, operating accounts are also
necessary for individuals, trusts, non-profit organizations, etc. However, these types of
deposit holders have fewer transactions when compared to business firms. Savings bank
(SB) account facilitates liquidity to these depositors.

A savings bank account however cannot be opened by banks in the name of:

– Government Departments.
– Municipal Corporations/Committees.
– Panchayat Samitis.
– Metropolitan Development Authority.
– Societies.
– State/District Level Housing Co-operative Societies, Housing Boards.
– Bodies depending on Budgetary Allocations for performance of their functions.
– Water and Sewerage/Drainage Boards.
– State Text Book Publishing Corporations.
– Any trading, business or professional concern whether such concern is a
proprietary/partnership firm/company/association.
– Any political party.

Similar to the current account, the banks do not generally require any advance notice for
withdrawals for the SB account. While the SB account also has cheque facility, only a
limited number of cheques can be written. Again, banks require the deposit holder to
maintain a minimum balance. While the required minimum balance may vary from bank
to bank, most banks require the depositor to maintain this amount on a continuous basis.
Some other banks require the depositor to maintain the minimum balance on an average
basis over a period of time, say three months. The bank may charge for any shortfall in
this minimum balance. Some of the new private banks are however offering zero balance
facility i.e. deposit holder need not maintain a minimum balance.

Interest Rates offered on Different Types of Deposits

Different deposit products generally carry different rate of interest. In general the longer
the maturity the greater is the yield the depositors earn due to the time value of money
and the frequent upward slope of the yield curve. For example, a customer can withdraw
NOW accounts and savings deposits immediately; accordingly the bank offers a rate that
is lowest of all deposits. In contrast, negotiable CDs and term deposits with longer
maturity often carry the highest deposit interest rates that a bank can offer.

The size and the perceived risk exposure of the offering banks also play an important role
in shaping the deposit interest rates. Other key factors are the marketing philosophy and
goals of the offering bank. Banks that choose to compete for deposits aggressively
usually post higher offer rates to bid deposits away from their competitors. In contrast
when a bank wants to discourage a type of deposit, it allows its posted rate to fall relative
to interest rates offered by its competitors.

As discussed earlier the current account does not have to pay any interest; however, the
SB account will earn interest for the deposit holder. The SB interest rates are prescribed
by the RBI and the prevailing rate is 3.5% per annum. This interest will be paid on the
minimum balance that is maintained in the account from the 10th to the end of the month.
This minimum amount is expected to be maintained throughout the month and a monthly
product is arrived at after multiplying this amount with the number of days in the month.
On this monthly product, the interest will be calculated (rounded to a rupee). Having
computed the interest amount, the bank will pay the same at quarterly or longer periods.
Normally the periodicity is half-yearly.

C). Term Deposits

Term deposits are a form of “debt investments” a customer lends, which in essence,
means that he is lending a sum of money to a bank or financial institution for a specified
period of time and the bank in turn pays him a “rental stream” (interest) for the privilege.
These accounts pay a higher interest rate than any other deposit accounts. This type of
account is sometimes called a certificate of deposit (or CD). These are the accounts of
funds to which depositors have no access for a fixed period of time and penalties apply
for early withdrawals. Cheques cannot be written on term deposits or CDs.

The other feature of the term deposit is the de-regulated interest rates. Banks are free to
set their own rates depending on the size of the deposit and the tenure.

Given the nominal rate, the effective rate can be computed as follows:

r=

Where,
r = Effective Rate
k = Nominal Rate
m = Frequency of compounding per year
Term deposits can be in any one of the following forms:
 Fixed Deposit Scheme
 Reinvestment Scheme
 Cash Certificate
 Recurring Deposit Scheme.

Fixed Deposit Scheme

In this scheme, a lump sum amount is deposited for a fixed term during which the amount
cannot be withdrawn. However, the interest is paid on a
monthly/quarterly/half-yearly/annual basis. This scheme provides liquidity to the
depositor as it can be withdrawn during these periods.
Consider the following mathematical expression:
X(1 + r/6) + X(1 + r/12) + X = Y
Where,
X = Monthly interest amount
Y = Quarterly interest amount
r = Reinvestment rate for the monthly interest.
Simplify the above equation by multiplying by 4.

4X

12X + 4X = 4Y

12X + 4X = 4Y

X (12 + r) = 4Y

X=

Thus,

Discounted Monthly Interest = ...Eq(2)

Where,
P = Principal/Fixed Deposit Amount
R = Interest Rate
r = Reinvestment Rate for the monthly interest
In the above expression, it can be observed that the first month’s interest amount is
reinvested for 2 months, the second month’s interest for one month. To these amounts,
when the third month’s interest is added, it should give interest that equals the quarterly
interest amount.
Illustration 3
For a 2 year FD deposit of Rs.50,000 with GNN Bank Ltd. (GBL), the interest rate is
10.5 percent.
a. Ascertain the interest amounts if the payment is made on a quarterly, half-yearly and
annual basis.
b. What should be the interest rate if the interest is withdrawn every month and
transferred to the savings bank account?
Solution
a. Quarterly interest amount = 50,000 x 0.105/4 = Rs.1,312.50
Half-yearly interest amount = 50,000 x 0.105/2 = Rs.2,625
Annual interest amount = 50,000 x 0.105 = Rs.5,250

b. Discounted Monthly Interest = = Rs.436.04

This can be verified by adding the monthly interest of 3 months; and the interest earned
during that period is as follows:

(436.04 x 3) + (436.04 x 0.04 x 3/12) = 1,312.50

Thus, the interest rate that GBL can pay on the Rs.50,000 FD, if the interest amounts are
withdrawn every month will be 10.46 percent (i.e. 436.04 x 12/50,000).
It can be observed from the above illustration that the interest that can be paid for a
monthly withdrawal FD scheme will be slightly lower to the rate paid for the other
interest payment periods.
As mentioned above the minimum and the maximum tenures for a FD are 15 days / 7
days and 10 years respectively. Due to the tenure and the liquidity, this deposit scheme
suits retired people, pensioners etc.

Reinvestment Scheme
In a reinvestment scheme, a lump sum amount is accepted for a fixed period and repaid
with interest on maturity. Interest on deposit is reinvested at the end of each quarter, and
hence there will be interest on interest.
the following expression can be used:
RIm = RI (1 + r)n ....Eq(3)
Where,
RIm = Deposit amount at the end of re-investment period
RI = Initial deposit amount
 r = Effective rate =

n = Number of years
If a depositor opens a re-investment account at BNB Bank Ltd. the interest rate offered
will be 9 percent for one year scheme, 10 percent for two years scheme and 11 percent
for three years scheme. Ascertain the maturity amount for a quarterly re-investment of
Rs.10,000 for a period of 2 years.

Solution : The amount at the end of the re-investment period can be

assessed as follows:
RIm = RI (1 + r)n
= 10,000 (1 + r)2
Since it is a quarterly re-investment,

r= = 10.38

Thus, RIm = 10,000 (1 + 0.1038)2 = Rs.12,184

Cash Certificates;
Type of reinvestment deposit scheme, odd sums are accepted for a fixed period to pay
whole sums at the time of maturity. The interest on deposits is re-invested quarterly and
hence there will be interest on interest. A deposit receipt which gives the details of
deposits will be issued to the depositor. The minimum and maximum durations are the
same as for the reinvestment scheme.

The issue price can be arrived at using the present value principle.
Issue Price = PV = Face Value (PVIFAn,k) ....Eq(4)
Where,
n = Tenure
k = Interest rate
Given the interest rate of 12 percent p.a. on a certificate having a value of Rs.100 after
one year, calculate the issue price of the cash certificate.

Solution

Effective rate (r) =

= = 12.55%

Issue Price (PV) = Face Value (PVIFn,k)

 =

= = Rs. 88.85

Recurring Deposit Scheme

In a Recurring Deposit (RD) Scheme, a fixed sum will be deposited every month for a
fixed period. At the end of the period, the depositor will be paid the total amount of deposit
installments with interest.

To arrive at the amount on maturity, the future value of annuity should be computed as
follows:
RDm = RD(FVIFAn,k) ….Eq.(5)
Where,
RDm = Maturity value of deposit
RD = Installment amount

Compute the maturity value of a monthly Recurring Deposit of Rs.500 for 12 months, if
the interest applied is 9 percent p.a. and is compounded quarterly.

Solution

Effective Rate (r) = = 9.31%

Rate of interest per month = = 0.78%

Maturity value = FVAn = A[FVIFAn,k]

=A

= 500

= 500 x 12.53 = Rs.6,265

Composition of Bank Deposit:

The different type of deposits that banks hold at any moment of time depends most
significantly on the public’s demand for deposit services. The next important factor is the
bank’s fund raising policies, including the services fee charged and the interest rates offered
by the various deposit plans, the aggressiveness with which different deposit plans are
advertised and the time and resources devoted to attract and retain the customers. Over the
years the most successful and readily saleable deposits that banks have offered are the
demand and time deposits.
Banks that offer lower than the market interest rates will have to meet for extra liquidity
demands that arise due to substantial withdrawals and fluctuating deposit levels. Faced with
substantial interest cost pressures, many bankers have pushed hard to reduce their non-
interest expenses like expenses on automating their operations and reducing the number of
employees on the payroll; and to increase operating efficiency.

All other things remaining the same, a banker would prefer to raise funds by selling those
deposits that are least costly for the bank. The banker would also prefer to sell those loans
that generate the greatest net revenue after all the expenses. If a bank can raise all its
capital from sales of cheapest deposits and then turn around and purchase the highest
yielding assets it will maximize its spread and the shareholder value.

Time deposits, CDs and money market accounts generally display low amount of activity
in terms of deposit withdrawals compared to the savings accounts and current accounts.
However the higher interest costs on most time deposits tend to offset the cost advantage
over the savings accounts.

Smaller banks incur higher interest costs on savings accounts than the larger banks but
offset this by issuing time deposits at a lower average cost than the average cost of time
deposits issued by larger banks. Nevertheless larger banks generate more revenue from
chequeable and thrift deposits because of the greater average size of these deposits at the
biggest banks.

Deposits form an integral part of a bank’s portfolio as they are the main source of funds.
Today most of the banks are able to sustain themselves on deposits and fee based income
given the background that the fund income is on a decline due to lack of credit offtake.
While in the global scenario several banks have experienced a decline in their core
deposits due to declining interest rates, the Indian scenario depicts a different picture. The
inflows into bank term deposits continue to be surprisingly large despite the fall in
interest rates.

Yet, bank term deposits attracted substantial inflows in the last three years (2001-03).
Investors in these instruments may need a change in strategy. Without a change in
strategy, the post-tax yield on their portfolio may well plummet below 4 percent. In the
case of selected public sector banks, the growth in inflows of term deposits has crossed
10% in the last three years. When investors are being coaxed to invest in equities to
enhance portfolio returns, the preference for bank term deposits is puzzling. In addition,
the bulk of the deposit inflows are into savings deposits and other shorter-term instruments.
For a public sector bank, savings bank deposits range between 12 - 20% of their deposit
base.

More than one-third of these customers do not even recall the last price change to their
checking accounts, and only 13% of those who do remember troubled themselves to shop
around for a better deal. In the end, just 2% of all customers moved their accounts. In a
2001 market research study of more than 500 banking customers in the US Southeast and
Midwest, by McKinsey & Company, Inc., a consultancy firm also revealed this
phenomenon. This is good news for banks: if they had more flexibility to price retail
products without sparking widespread customer defections, they could boost their bottom-
line retail earnings by as much as 5 – 7%.

A bank that can fund most of its funds with deposits will have an interest cost-advantage
over competitors with lower proportions of deposits, all other things being equal. The
bank also has to keep the public preference in mind while offering deposit products. In
the recent past, public has demanded both high yielding thrift accounts and chequeable
deposits that pay interest rates comparable to returns in the open market. At this juncture,
the deregulation of financial markets has made it possible for more kinds of financial
service firms to respond to the public’s deposit preferences. This combination of greater
competition and higher costs helps to explain why bank profits have become more
volatile and uncertain in the recent years.
Gist of the Chapter-IV

• The transaction and the non-transaction accounts have been among the most
important of all financial services provided by banks, principally because of their
safety, convenience, flexibility and explicit or implicit returns to the customer.

• The combined total of transaction and non-transaction deposits is one of the most
important financial assets for most of the households. It is not just essential for the
banks to have a good deposit base equally important is the composition of these
deposits.

• Savings and the Current account becomes essential for the bank firstly, to know its
liquidity requirements.

• As the liquidity and the cost of funds are affected by the composition of the demand
and the time deposits, these deposits have a direct impact on the growth and the
earnings of the bank.