Certificate of Deposit (CD): A Key Banking Strategy in 2023

What is a Certificate of Deposit (CD)?

A Certificate of Deposit (CD) is a financial instrument provided by banks, allowing investors to deposit a lump sum for a fixed duration at a predetermined interest rate. Recognized as a low-risk investment, it ensures that at the end of the specified term, investors receive their initial deposit along with the earned interest.

Current Scenario

Between April and August 2023, there has been a notable increase in CD issuances, primarily driven by public sector banks striving to meet escalating credit demand that exceeds deposit growth. Data from Prime Database indicates that CD issuances surged to ₹2.62 trillion this year compared to ₹2.5 trillion in the same period last year. The CD market experienced fluctuations, particularly in August 2023, influenced by the RBI's directive for banks to maintain 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

Several factors are driving banks to issue more CDs:

• Cost-Efficiency: CDs provide a cost-effective means for banks to raise funds compared to other financial instruments.
• RBI's Mandate: The higher CRR requirement has tightened liquidity, prompting banks to use CDs to strengthen their liquidity positions.
• Stabilized Rates: Unlike the previous year, when interest rates were frequently increased, the current stability offers banks a favorable environment for issuing CDs.
• Festive Season and Tax Outflows: Anticipated festive spending and tax payments are expected to sustain the trend of heightened CD issuances.
• Liquidity Management: In fluctuating liquidity conditions, CDs serve as a crucial tool for commercial banks.

Bank Participation

Public sector banks dominated the CD market, accounting for over 65% of all issues with a 30% increase year-on-year. Major players included Canara Bank, Punjab National Bank, Bank of Baroda, and Indian Bank. Meanwhile, private sector banks contributed 26% of CD issuances, reflecting a 25% decrease from the previous year, with Axis Bank and IDFC First Bank leading the private sector.

The Question Arises: Why Can’t Banks Hike Deposit Rates Instead of Going for CDs?

Banks may choose not to raise deposit rates for several strategic reasons:

• Cost Management: Increasing deposit rates raises operational costs due to higher interest payments to all depositors. CDs allow controlled fundraising at specific rates.
• Maintaining Profit Margins: By keeping deposit rates steady, banks can protect their interest spread, ensuring profitability.
• Liquidity Management: CDs provide flexibility with varied maturities, aiding liquidity management more effectively than standard deposits.
• Market Dynamics and Competition: Avoiding deposit rate wars helps prevent unsustainable market conditions.
• Regulatory Requirements: Banks must comply with regulatory norms, and CDs can help meet these more efficiently than raising deposit rates.
• Attracting Large Investors: CDs appeal to large investors looking for better short-term returns, diversifying the investor base.
• Control Over Tenure: CDs permit banks to manage deposit tenures, addressing asset-liability mismatches effectively.
• Quick Fund Raising: Banks can swiftly gather funds through CDs for immediate liquidity needs, unlike gradual deposit rate increases.
• Customer Behavior: Changes in deposit rates may not immediately influence customer behavior, as adaptation takes time.

Conclusion

While raising deposit rates is an option, it poses challenges. CDs present a more flexible and targeted strategy for banks to raise funds and manage liquidity, offering a strategic edge in the current economic climate.

Frequently Asked Questions (FAQs)

Q1. What are the advantages of investing in a Certificate of Deposit?
Answer: Certificates of Deposit offer a guaranteed return over a fixed period, making them low-risk investments. They often provide higher interest rates than regular savings accounts, allowing investors to earn more on their deposits.

Q2. How do Certificate of Deposit interest rates compare to traditional savings accounts?
Answer: CD interest rates are typically higher than those of traditional savings accounts due to the fixed term of the investment. This means investors can earn more by committing their funds for a specified period.

Q3. Can I withdraw my funds from a Certificate of Deposit early?
Answer: Yes, but early withdrawal often incurs penalties. It is advisable to choose a term that aligns with your financial needs to avoid such penalties.

Q4. What role do CDs play in bank liquidity management?
Answer: CDs help banks manage liquidity by allowing them to raise funds quickly for specific durations, which is crucial during times of fluctuating cash flow needs.

Q5. Why are public sector banks more active in issuing CDs?
Answer: Public sector banks often issue more CDs to meet regulatory requirements and manage liquidity effectively, especially during high credit demand periods.