Flight to safety is becoming a problem in the financial crisis. Mistrust of markets is leading to selling off other assets and lending only to governments. This has set off difficulties in the markets for assets that are being sold, and a precipitous drop in interest rates for safe government bonds. In the US, the 90-day treasury bill had seen a collapse in the interest rate from 1.46% on 12 September to 0.03% on 17 September. It has, since recovered to 0.45% on 16 October, as some money has returned to risky assets in response to the massive efforts by governments to save the financial system from a collapse. Some similar symptoms have been observed in India also. Substantial redemptions have taken place of mutual fund units, particularly the schemes with investments in real estate companies. This money has to find a safe home. In perhaps related developments, the interest rate on the 10-year government bond has dropped sharply from 8.66% on 29 September to 7.71% on 16 October.
In this setting, there is one incongruous development. PSU banks should ordinarily have been beneficiaries of this `flight to safety'. They should have scooped up deposits on the strength of their in effect unlimited deposit insurance bestowed by the government. However, in recent weeks, several PSU banks have raised deposit rates. These moves need to be questioned. At a time when PSU banks should have been cutting rates in line with the nearly 100 basis points decline in the 10-year government bond, and at a time when PSU banks should have been getting increased deposits simply on the strength of their government guarantee, why should their interest rates be raised?
In the worst scenario, these decisons by PSU banks could set off further dislocations in the financial system in their own right, for this places stress on all other financial assets on the economy which have to produce higher returns given that PSU banks are offering higher fixed rates. Further, since an RBI repo cut is widely expected and the point of that is that lenders reduce their rates, high cost deposits do not appear to be the best way to prepare for this change. Will we hear arguments from public sector banks that their costs preclude substantive lending rate reductions? That's a scenario the government, owner of PSU banks, should anticipate.