How depositors lose out on Islamic savings accounts

The increase in interest rates to almost all-time high levels, coupled with a super tax on bank profits, as well as an arbitrary tax on advance-deposit ratios of banks has led to a need for reducing cost of deposits, such that profitability of banks can be maintained, or increased. 

Banks continue to act as conduits for sovereign borrowing, with direct, or indirect loans to the government making up more than 70% of their asset base.  Under normal circumstances, a typical bank would try to attract a greater proposition of current accounts on its liability side, such that it can reduce its overall cost of deposits. The other options being savings accounts, and term deposits. 

Retail depositors are often not the most financially suave, so they get the short end of the stick, as they either maintain current accounts, or savings accounts.  To clarify, a bank does not have to pay any profit, or interest on a current account; it is essentially a non-interest yielding account. However, a bank has to pay an interest on a savings account, which is linked to the policy rate that is set by the central bank. As the current policy rate is 17%, the minimum savings rate that banks have to give to its depositors maintaining a savings account is 15.5%. The minimum savings rate is linked to a floor rate, and is 0.5% less than the floor rate, which is currently 16%.

However, the same minimum savings rate is not applicable on Islamic banks, which leads to all kinds of distortions.  

Firstly, the depositor is simply not aware that they can get a fairly decent rate on their savings account. This is exploited by Islamic banks, as they offer a much lower rate on savings accounts than what is available in the market otherwise. The depositors thinking that they are on the path of shariah, are actually being swindled by the bank, which is often giving them a below market rate, and benefiting massively from the information asymmetry. A simple exercise to compare the weighted cost of savings accounts of Islamic banks, and conventional banks can validate the same.

Over the last few weeks, conventional banks have also now caught up on the trick. Depositors across the board are getting calls from their banks to convert their conventional banking account into a shariah-compliant banking account.  Being victims of information asymmetry, depositors consent to the same, not realising that they will get a considerably low return on their savings account in this high-inflationary, and high-interest rate environment.

Banks often use the government’s lopsided and short-sighted plan to convert all banking to Islamic banking as a reason to convince people to convert their accounts. The conversion pitch is made, such that the depositor does not have any other option. Banks continue to make hay, and massive interest rate spreads on the financial illiteracy of the depositor, while the regulator continues watching from the sidelines.

There exists a strong case to link the savings rate of shariah-compliant savings accounts with a benchmark, similar to the case of conventional savings accounts.  There may exist some complexities regarding the inability to comply with certain shariah principles, but such principles also discourage from taking undue advantage of people, who do not know any better, and are victims of information asymmetry.

The country is undergoing a spell of inflation that has never been seen before, and it is only expected to get worse. As the central bank plans on potentially increasing policy rates, the interest rate spread that banks can extract from unknowing depositors is only going to increase. To preserve income, and wealth to a certain extent, there is a compelling case to rationalise deposit rates available to depositors. More importantly, it is crucial that banks do not force conversion, and are not mis-selling certain features to achieve short-term quarterly targets, while hurting the real incomes of people.

The trust of the public in banks is already at an all-time low, if currency in circulation is considered, with more than Rs 8 trillion of currency in circulation, making up almost 20% of GDP — which is its highest level ever. If people are not able to conserve their wealth, and incomes in banks, they are only going to move capital to the informal economy, thereby reducing capital in the formal economy in the process.

Banks, the government, and the regulator need to take a view here. We can either take a short term quarterly view of things, and extract a pound of flesh from the depositor, or we can gain trust of the depositor for longer-term capital accumulation.