How bank fixed deposits have a skewed risk-return equation

The safety that bank fixed deposits offer is too expensive. This illustration can be an eye-opener. 

A majority of Indians do not save. Yes, now a majority has a bank account, and many receive their salaries or income via a bank account. But most of it is immediately withdrawn and spent. For a minority of investors, the money is left in the savings account until it is spent. A still smaller minority does not spend all the income and has some savings. These are the heroes of the Indian financial industry; they put their savings primarily in bank fixed deposits. Some of our heroes shop around for banks and invest in the ones that provide higher interest on their deposits.

The bank deposits give them a feeling of safety. (Practically all of us, including the most sophisticated financial and investment experts among us, indulge in this.)

How exactly are banks providing the returns or interest on fixed deposits? What is the ultimate source of these returns?

The first thing to understand, and this may come as a surprise to many, is that banks are not there to serve us, the depositors. The real customer of a bank is the borrower. So, typically, the lending teams at banks are sourcing potential borrowers and the credit analysis team is carrying out due diligence on projects and companies. A pipeline of projects that can be lent to exists at any point of time. The moment we go and deposit our money in a fixed deposit, the money is allocated to one of these borrowing companies. The companies commit to paying a certain interest rate to the bank for this. This is the primary source of income for the bank, from which it deducts its running expenses and some profits and then pays the rest to the depositors as interest on their fixed deposits.

Typically, when a bank is paying 6% to depositors, it is lending at 10-12% (or even higher) to borrowers. Of course, some borrowers are deemed "safer"; they get lower rates. The "riskier" borrowers get higher rates. So, effectively, as a depositor in bank fixed deposits, you are lending to companies. The bank is acting as your asset manager and charging an asset management fees of 4-6%. (For more efficient banks this could be lower, but usually it is not).

How do companies pay the interest? They invest the money in assets that will generate returns. A typical Indian company is able to generate 15-25% on its assets. From this they have to pay the interest to the bank. So, a company that can generate a return on assets of 20% and has to pay even 15% as bank interest, is still able to make a profit of 5%. If this company has financed half of its assets with debt, the returns for shareholders would be 25%. If it did not use debt at all, it is still generating 20% for its shareholders.

So the ultimate risk exposure for a bank fixed depositor is the same as investing directly in the company. Of course, the bank loan has a priority over the equity shareholders of the company and hence is "safer". Further, the bank fixed depositor has a priority over the bank shareholders and hence the fixed deposit is safer. Plus, the bank has lent to a diversified portfolio of borrowing companies. That too makes it safer. The bank credit analysis team has expertise in evaluating companies and their projects, which adds to the safety.

But there is a cost of getting this safety.

That cost is the difference between the company shareholder getting 20% (or 25%) versus the bank fixed depositor getting 6-7%. If you are investing in bank fixed deposits at 6% and keep renewing it over a period of 15 years, your initial money will become about 2.5 times during this time. Contrast that with if you had directly invested in the borrowing company, earning 20% return on equity. Your money would be 15.5 times. At 25%, that goes up to 28.5 times. So if you had invested Rs10 lakh in the bank, you would end up with Rs25 lakh after 15 years; while the person investing in the company would end up with Rs1.5 crore.

A typical working life of 30 years to build a retirement corpus with bank deposits versus investing in company equities shows that the cost of safety for the bank depositor is extremely high. Over a 30-year period, the 6% bank depositor's Rs10 lakh will end up becoming Rs60 lakh (net of taxes, it would be Rs35 lakh). Over the same period, the company equity investor's Rs10 lakh will end up becoming Rs24 crore (net of taxes, it could remain Rs24 crore, or if the company is unlisted, then with long-term capital gains tax of 20%, it would become Rs19-20 crore). This means the cost of safety is about Rs20 crore.

To make the equity investment process safer, one has to develop the expertise of the bank's credit analysis team; has to have equity analysis expertise; has to diversify the portfolio; be alert and monitor the portfolio regularly; and not pay the huge cost of safety. This is possible-you can do this yourself, or through an asset manager. One can recreate a significant portion of the safety of a bank deposit at a much lower cost than Rs20 crore.