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Interest Rates Are Also About Savers, Not Just About Borrowers

Jun 10, 2016


One of the points that I have made in the past is that interest rates are not just about borrowers; they are also about savers.

Raghuram Rajan, the governor of the Reserve Bank of India (RBI) explained this beautifully in a recent interview to NDTV. At a talk somewhere, one gentleman got up and told the governor that he should bring down the interest rates to 4%.

A point that most people fail to understand is that an RBI governor can decide only on the repo rate. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

The RBI governor does not decide on the interest rate that a bank charges on its loans. Neither does he decide the interest rate a bank pays on its deposits for that matter. That is a decision individual banks make. Hence, Rajan cutting the repo rate is not enough. Banks need to pass on the cut to the end consumers. Since January 2015, Rajan has cut the repo rate by 150 basis points. Banks have passed on around half of that cut to the end consumers due to various reasons. The public sector banks have been accumulating a huge amount of bad loans and this has limited their ability to cut interest rates on their loans.

Rajan asked this gentleman that the rate of inflation was still 5.5% and if he brought down the interest rate to 4%, would he still deposit his money at the bank? The gentleman said no. So he was not willing to deposit his money at a low interest rate, but wanted banks to lower their lending rates.

To this Rajan said: "say a bank pays 6% on deposits and lends at 4%, who is going to make up for the difference". "The idea is that somebody is going to pick up the tab. We are used to somebody picking up the tab. Who is going to pick up this tab?"

The point here is very simple. A bank can only lend at a rate of interest which is higher than the rate at which it borrows. Further, it needs to offer a certain rate of interest on its deposits, so that people deposit money with it and do not invest it in other avenues which offer a higher rate of return. Currently, the rate of interest offered on small savings schemes are significantly higher than those of fixed deposits.

Rajan also said that it takes some time for depositors to get used to the fact that inflation has actually come down over the last few years. "The real interest rate they [i.e. depositors] are getting now is much higher than the real interest rate they were getting earlier," Rajan said. The real interest rate is essentially the nominal interest rate offered by a bank on its fixed deposit subtracted by the prevailing rate of inflation. "When inflation was 9% they [i.e. depositors] were getting 9%. This meant earning nothing in real terms and losing everything in inflation," Rajan explained. "Today they are getting 7% on their deposits and inflation is 5.5%. They are earning 1.5%. It is a real difference," he added.

This is something that will take time to sink in because money illusion is at work. What is money illusion? As Gary Belsky and Thomas Gilovich write in Why Smart People Make Big Money Mistakes: "[Money illusion] involves a confusion between '"nominal" changes in money and "real" changes that reflect inflation...Accounting for inflation requires the application of a little arithmetic, often an annoyance and downright impossible for many people...Most people we know routinely fail to consider the effects of inflation in their finance decision making."

So, the point is that even though people are earning a better real rate of interest they don't realise it. What they see is that nominal rate of interest has fallen and given this they are not happy with banks offering a lower rate of interest on their fixed deposits.

As Rajan said in the NDTV interview: "Depositors are already complaining that they are not getting enough. That is why banks are reluctant to cut [deposit] rates." And unless banks can cut deposit rates there is no way they can cut lending rates, irrespective of what the RBI chooses to do with the repo rate.

This is how bank interest rates work. As Rajan asked: "For somebody to say that I have a God given right to get a loan at low interest rate but I won't deposit at that rate, where is the money going to come from them?" This basically means that banks lend money they essentially get as deposits. And without deposits there is going to be no lending.

"One of the most difficult things in economics to understand is general equilibrium. You do one thing it has other effects as well," Rajan said. If interest rate on lending is cut where is the money going to come for savings, Rajan asked.

This is something that people who keep demanding lower interest rate at a drop of a hat don't seem to understand. There are two sides to bank interest rates. The interest rate banks charge on their loans and the interest rate they pay on their deposits. And if interest rates on deposits can't fall beyond a point, then the interest rate on loans can't fall as well.

This is a basic point that people don't seem to understand. And it's not rocket science.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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8 Responses to "Interest Rates Are Also About Savers, Not Just About Borrowers"


Jun 13, 2016

A VERY GOOD ANALYSIS MR.VIVEK. Big borrowers want rate cut and expect the borrowings to get cheaper.
politicians want ZERO interest rate to put the economy on steroids. Disciplined and hard working middle class and pensioners expect the rates above than rate of inflation. The only good thing that the UPA did was to appoint MR.Raghuram rajan as RBI chief. I am afraid that the political nominees in the proposed monetary policy committee will listen to their political masters which may distort the
equilibrium after the exit of the present Governor.


Sreedhar Krishna Murthy,

Jun 11, 2016

Domestic savings is an integral part of a nation's economy. Banks mobilise deposits through SB a/cs and term deposits and lend such money for consumers/ business houses. Considerable no. of people depend upon return on their deposits for their sustenance. There is no social security cover for every one,like in the West where state takes care of all citizens of their basic needs. Therefore, depositors must be rewarded reasonably. In the high inflation regime, depositors stand to lose their net worth over the years, although they may get interest, unless the interest income rate much above inflation rate. One cannot run counrty;s economy by borrowing funds from other countries like Japan or US where interest rates are low. FIIs pension funds etc from West etc come to India to invest in Stock market as the interest rate there has plummetted. What will happen when the foreign funds/ FIIS withdraw their deposits suddenly, is unthinkable. We have seen the impact when they decide to withdraw from market! Country's economy cannot depend on foreign funds. Banks need to improve efficiency and work lesser spread/ margin than about 4%. If the NPAs are brought down the margins would improve and the NII can be about 2%, offering decent returns on deposits and at the same time lending at reasonable rates for businesses. India has seen interest regime of around 15% in the recent past and much higher earlier. Pvt. lender charged/ charge over 36% even now..Should the depositors look for investment with such unreliable lenders????? A fine balance needs to be struct between deposit rates and lending rates. Western countries and Japan etc have very few options in regulating inflation as interest rate tool is reduced to NOTHING as rates on deposits have come down to 1% and sub 1%. Should we adopt this model for India? A consumption based economy has its own limitations.



Jun 10, 2016

Interest Rates Are Also About Savers, Not Just About Borrowers. If interest rate on lending is cut where is the money going to come for savings, Rajan asked.This basically means that banks lend money they essentially get as deposits. And without deposits there is going to be no lending.There are two sides to bank interest rates. The interest rate banks charge on their loans and the interest rate they pay on their deposits. And if interest rates on deposits can't fall beyond a point, then the interest rate on loans can't fall as well.This is a basic point that people don't seem to understand. And it's not rocket science. Would our FM and the sponsored business channels who advocate reduction of interest rates at the behest of business houses and other politicians understand this basic principle that Deposit rates cannot go down beyond a limit and it cannot be less than INFLATION RATE, AND UNLESS DEPOSIT RATES cannot be reduced, interest rates on loans cannot be reduced. Also think of DEPOSITORS once, who are basically lower middle class, middle class, pensioners, who heavily depend upon interest income for their sustenance.

What more needs, more succinctly as Mr Rajan said on reduction of interest rates. No one has said it more explicitly than Mr Rajan. Mr Vivek has summed up the ideas very effectively. No more comments.


Sundaravaradan S

Jun 10, 2016

Hi Vivek Kaul Explained the RBI Governor's point Very clearly. Nice to note.
Ban-Loan-Lending-Rate = (Bank-Depositor's-Rate + ( Bank-Profit + Bank-Enxpenses)).

Repo-Rate = Rate-RBI-pays for the compulsosory deposit of Bank (SLR) by Bank to RBI.
These 2 rates are NOT REALLY related..

Why should they be ?????
Why RBI can not Reduce the SLR ????
Why not INCREASE cover the Depositors Amount by Insurance? (1 Lakh to 10 Lakh, Auto increased by Inflation p.a.) By DICGC (Google it).

Needs Deep Thinking. ( Stop Corrupt Lending...)


M Subramanian

Jun 10, 2016

One point that is missed out is on the actual inflation rate which is much higher than 5.5% . The retail inflation and the price of the commodities have gone up by 10 % to 20% and with the steady increase of oil prices this is likely to go up. We can expect constant increase in the petroleum products. The present interest rates on FD itself is not attractive and especially for retired people who count on such regular income. Everybody will be out of pocket unless the cost also comes down where the potential to save should be more which is not likely to happen.

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manmohan khetan

Jun 10, 2016

Thanks Vivek for explaining so nicely & simple language without using jargons.

Like (1)


Jun 10, 2016

Mr Rajan understands that there are millions of Senior Citizens who retired from private industry. They do not have the advantage of CPI linked pension plan the ex-Government & ex-Bank employees have....they have to live only on the interest they earn on their Provident Fund-which seems to be shrinking day by day ! What happens to these millions ? where do they go ? especially if they have no childreen supporting them !

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Jun 10, 2016

This is such a superficial understanding of how interest rates work that People would not deposit money if the interest rates are less than inflation. It may be true to some extant but why is that considered a doomsday scenario. Is it ordained that people should deposit money and banks should make a clear 2 %. This kind of thinking is flawed. The decision to invest in a bank is not based on inflation but on business returns. If equity is giving better returns, why invest in FD. FD investment is for people who play it ultra safe. If you start paying high returns on ultra safe investments like FD's then the game is clearly rigged. No one will ever do business and take risk. in other words there will be no economic activity.

Also more people in India today are burdened with loans and not savings as you seem to think. Allow market forces a free play. Let Japanese banks lend to people in India at say 2% and not protect inefficient indian banks to make 2 % profit as if it were some god given right. Why should indians pay for inefficient banks.

Banks are meant for a different purpose. The banks main service is to facilitate handling of money and their efficiency should be increased. Investment is only a side business for banks and not their main service. You cant force everyone to keep money in FD. Savings bank accounts are banks only assets.

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