BT Insight: Should you invest in high interest rate FDs of small finance banks?

People who invest in fixed deposits have witnessed continuous fall in interest rates which have touched a record low seen in a decade. Given the economic slowdown due to coronavirus pandemic there is remote likelihood of rates going up significantly in the near future. Big banks, whether from public or private sectors, are offering quite low interest rates. In such a scenario depositors are getting attracted to small finance banks that are offering much higher rates on their fixed deposits. Many depositors need higher rates on their FDs but the recent crisis in PMC Bank and YES Bank suggests few of them will dare to take chance with their hard-earned money. So what should you do?

Interest rates are quite attractive

Senior citizens who primarily depend on FDs to manage their retirement expenses, have seen their income falling drastically within few years. When all major big banks are offering interest rates around 6 per cent the rates offered by many small finance banks look quite attractive. "The highest FD slab rates offered by these banks range anywhere between 7.5-9 per cent per annum, which are at least 200-300 bps higher than what are being offered by PSU banks and most private sector banks," says Sahil Arora - Director & Head of Investments, Paisabazaar.com.

Big banks are sitting on huge liquidity and are less inclined to get more deposits. However, the same is not applicable with small finance banks. "Fixed deposits especially with major banks are considered safest form of investment. However, small finance banks comparatively offer higher interest on FDs than major banks as they want to attract more customers," says Col Sanjeev Govila (Retd), a Sebi-registered investment advisor.

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How safe are these FDs

Returns are always linked with the risk associated with the investments. "Investors need to realise that risk and return are correlated. With higher returns come higher risks. So one can invest in FDs of small finance banks, but the exposure should be restricted," Col Govila (Retd). Therefore, one has to stay cautious before going for any investment with these banks.

However, there are some comforting factors as well. Unlike the co-operative banks these banks are directly regulated by the RBI. "Small finance banks have also been categorised as scheduled banks by the RBI just like PSUs and other private sector banks. Deposits opened with scheduled banks are protected by the deposit insurance program of DICGC, an RBI subsidiary, in case of bank failures," says Arora of Paisabazaar.com.

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Besides, the deposit insurance cover has been significantly increased on bank fixed deposits from Rs 1 lakh to Rs 5 lakh. "This insurance cover is applicable to each depositor of each scheduled bank for their cumulative deposits (total deposits in savings, current, fixed and recurring account) of up to Rs 5 lakh. Hence, having cumulative deposits (including fixed deposits) of up to Rs 5 lakh with each of these small finance banks is as safe as having deposits with PSU and large private sector banks," says Arora of Paisabazaar.com.

Challenges in investing in small finance banks

As their names suggest these are small banks with few branches concentrated in a smaller geography. Therefore, many investors looking to invest in these banks may not find a branch nearby to open their account. Online account opening is still not a reality and depositors will have to wait for some time for many of these banks to start offering online account opening facility.

Should you invest?

Since risk of investing in these banks cannot be ruled out, you need to be cautious. "To ensure maximum level of capital protection for their fixed deposits, depositors can spread their fixed deposits across multiple banks offering higher FD rates. in such a way that cumulative deposits with none of them exceed Rs 5 lakh," says Arora of Paisabazaar.com. So make sure that your total deposits in the selected bank including the maturity amount of your FD is not more than Rs 5 lakh.

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If you have higher amount to invest then you should rather do it in parts. "Moreover, given that an insurance of up to Rs 5 lakh is available against bank deposits per bank, don't put above Rs 5 lakh in one small finance bank. If you have to invest Rs 20 lakh, invest it in four different banks so that the entire amount remains secure," says Col Govila (Retd).

Besides, you also need to make sure that you do not commit a major part of your portfolio in these FDs. "Out of  total funds earmarked for FDs, an individual should not put more than 10 per cent in FDs of small finance banks. The rest can be allocated to FDs of large banks, debenture, perpetual bonds and debt mutual funds," says Col Govila (Retd).