The government’s new FRDI law seems to be the biggest news after demonetization! People are very sensitive about money, and there is a lot of interest in saving commission by investing in direct plans of mutual funds. Various mutual funds apps and calculators are also in use to compare the returns. They have worked so hard for it. The new regulation has raised lot of doubts and in this post we will cover debt mutual funds ( direct plan mutual funds, of course) are still the right Investment products for us, over Bank Fixed Deposits, never mind the FRDI regulation..
The answer to the above question is not difficult. Almost everyone would point towards the safety offered by the product. Yet another reason could be the liquidity offered by the bank. In simple terms, the bank is making an offer to you to keep your money safely along with a promise that the money would be returned to you any time you ask for it. Our experience with the bank also suggests the same. Whenever we have gone to the bank, asking for our money, we have always got it back. It is this faith in the banking system that is the foundation of the banking industry. If people lose faith in the banking industry, the banking industry will simply collapse!
The third aspect of returns on the investment is something we will discuss towards the end of this article.
The plain and simple answer is No. There is no “guarantee” that the money will be given back to you. There are many instances of failed Banks not returning money to depositors. Thankfully, our banking regulator (read RBI) has been very conservative and has ensured that banks remain financially strong. However, if there is a crisis and a bank incurs huge losses, and is not in a position to repay back the money taken as deposits, there is no regulatory protection to depositors. Thus, contrary to popular belief, money in the banks is NOT risk-free.
CAR – Regulators across the world realize that it is important for depositors to feel that their money is safe. Thus, Banks are required to maintain minimum amount of capital. You must have heard about CAR, which stands for Capital Adequacy Ratio. In simple terms, CAR specifies the amount of capital that banks must maintain mandatory. Now, how much capital is adequate? Conceptually, banks must maintain capital that is MORE than the amount of losses it is likely to incur. There are lots of calculations that go into calculating all possible losses, including stress scenarios. Readers will be happy to note that all the banks in India maintain the required CAR.
Deposit Insurance – Another simple mechanism to protect any asset is to insure the asset. AS per the Deposit Insurance mechanism, banks insure their deposits upto Rs.1 lakh with an organization called DICGC. As a result, if any bank fails to repay its deposits for any reason, the DICGC will make good the loss to the extent of Rs.1 lakh. This is like any other Insurance scheme.
It is not out of place to state here that the amount of Rs.1 lakh was decided in 1961 and has remained unchanged ever since. Compare this with the USA. THE FDIC protected deposits to the extent of USD2,500 in 1933, when it was created. The limit now is USD250,000, an increase of 100 times! So much for the adequacy of deposit insurance!
Hence, banks offer safety on the basis of the above and not because of any Government guarantee. Bank deposits are not “risk-free”. Given the requirements of CAR and Deposit Insurance, the risk is low. But the risk exists!!
FRDI stands for Financial Resolution and Deposit Insurance. Very simply stated, the FRDI Bill proposes to create a system wherein there is an early warning of the possibility of a failure of a financial system and the steps that can be taken to resolve the situation. Attempt would be made to restore the financial institution back to health. However, if that is not possible, then steps are taken to close it down in an orderly manner.
Let us understand this situation with a medical analogy. Suppose, a family member is detected to be terminally ill (suffering from Cancer). How would you want to react to the situation? All possible efforts would be made to fight the disease. If it is detected in early stages, there is a strong possibility that it would get cured. If it is detected in later stages, you would treat the patient in whichever way you can, but you will ultimately reach a situation where you only pray that the patient passes away without suffering and that the near and dear ones of the patient also do not go through the pain.
The FRDI tries to do the same thing. Thus, without getting into the details of what is done, suffice it to say that it is a step in the right direction. Financial Institutions might get closed down, but that would happen in an orderly fashion.
So, why the panic?
The reason why FRDI has resulted in panic among the depositors is on account of a particular clause in the bill, which is called the “Bail in” Clause. We need to understand what this clause is and how it works.
Let us say, a Bank has started with Rs.100 as its capital and has taken Rs.400 as deposits. It lends Rs. 500 to various borrowers. One of the borrowers, who has borrowed Rs.200 from the bank, has run into losses and is not paying his installments to the bank as promised. This can mean that the bank will lose Rs.200, which is more than the capital invested by its owners. In other words, a part of the loss has to be borne by the depositors.
As a consequence, the bank will have to be closed. The depositors money would be recovered to the extent money is collected from sale of its loans to other Financial Institutions and from DICGC (the Insurance company). In case the amounts so collected happen to be less than Rs.400, then depositors will lose money. In most cases, Governments will come to the rescue of depositors and make-up for the loss. However, Governments do not have to do it. This is the current situation.
Instead, what the FRDI Bail in Clause suggests is as follows. If it is felt that this particular borrower is facing a temporary problem and can overcome the problems at a later date, and that the bank should continue to survive as there is hope for its recovery, some of the depositors are asked to convert their deposits into equity. In other words, depositors become share-holders. Thus, they are no longer providers of loan, where there is a promise that their money will be paid back. Instead, they become owners of the bank. In future, as the financial position of the bank improves, the depositors, who are now share-holders, will get the benefits as share-holders. This way, the bank survives and the depositors too.
This is way too simplistic and as a depositor, you may not want to be a party to such a deal. You may be happier collecting whatever you get and let the bank close. (Although, in reality, we are not prepared to take that loss as we always believed that banks are safe and we would expect the Government to bail it out and not us!). So, the good news is that you can choose to be in that situation.
Firstly, the bail in clause does not specifically include public deposits in the list of liabilities of which the clause will apply. Kindly note that Banks have other liabilities apart from public deposits. Thus, bank deposits need not be part of the bail in provisions.
Secondly, although it is not specifically stated, the spirit of the bail in clause implies that the bail in has to be voluntary. In other words, the holder of the liability must agree to his/ her deposit/ liability being subject to the bail in clause. If you are not comfortable with it, then you can opt out.
If all this is scary and if you feel that you would have never deposited money in a bank if you knew that the deposit is not 100% safe, then let us brace for one more bitter truth. Suppose, you decide that you will withdraw all your deposits from the bank. Where will you invest? Obviously, you cannot horde cash, as Government is increasingly dis-incentivising the use of cash. You will have to invest, which could be Bonds, Government Securities, Equity Shares, Post -Offices, Sovereign Gold Bonds, Mutual Funds, etc. There are so many choices in today’s world.
Pause here for a moment. How will you invest this money? By writing a cheque, doing a NEFT/ RTGS, IMPS, etc. What does each of this mean? It means that money will be deducted from your BANK Account and get added to some other BANK account! In other words, the money is still held in a bank and is exposed to the risk that you were exposed to earlier as a depositor! Thus, there is no escape from the risk of a loss from bank deposit.
Should that worry you? On the contrary, it should free you from the worry. We all know we will all die one day. It is a certainty. No matter what we do, we cannot escape this situation. So, do we worry about it, or simply not worry about it? Of course, we will take care of our health and take all steps to prevent the inevitable death, but we will not fret over the fact that we will eventually die. Similarly, there is no escape to the risk of keeping money in a bank, irrespective of the investment vehicle chosen, and hence, it is better to just live with this risk rather than fret over it. It is direct risk vs indirect risk, but there is no way you can escape from the risk!
So, long story short, FRDI strengthens the banking system and there is no need to take money out of the bank because of FRDI.
Bank Deposits are one of the most inefficient investment platforms due to taxes; compounding suffers giving a lesser return. Bank deposits can be part of your portfolio, but it will largely meet your need for liquidity. Both from a risk and return perspective, investment in direct mutual funds catering to liquidity needs, offer a superior alternative.
When you invest in a liquid or short term debt fund, a fund manager is actively looking at the market and taking a call based on the money market situation. Debt mutual funds are mainly invest in debt and fixed income securities such as Treasury Bills, Gilt funds, money market instruments etc. Just like the equity markets, money markets are dynamic. It allows liquid fund managers to make money based on interest rate movements and the prevailing liquidity situation. Thus, your money is actively managed and is likely to earn a much higher return. Since the money cannot be invested in any one organization or group of organizations or industry, the benefit of diversification or the spreading of risks, reduces the risk.
Money can be withdrawn any day. No questions asked. No exit loads. Atleast, the Jama picks ensure that there are no exit loads. So, liquidity is taken care of. Lastly, existing tax laws are skewed in favour of mutual funds compared to the interest on Bank Fixed deposits.
Thanks to various posts here, we are now well-aware that the post- tax returns on debt mutual funds clearly out-perform returns on fixed interest-bearing securities as well as inflation.
There is no real incentive to invest in Fixed Deposits. As we understood earlier, they are not risk free. The returns after adjusting for tax and inflation, are negative. They score better on liquidity, but direct plan liquid funds are almost on par, with some funds even offering ATM cards for instant withdrawal of money.
Remember, you make more by investing in “direct” mutual funds and Jama is the ideal platform for the same. Happy investing!
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