What does a Middle Class Indian want ? High returns with low risk .They want to protect their capital while earning high and quick returns . When they hear the word “FD” . They immediately jump on “FD bandwagon” and park their money in it .

They do it just by hearing 9% annual return and assume that since the product is an FD , it is bound to be safe. Here comes a dark twist in their supposedly fairy tale , the bank fails and the deposits get frozen. Wrapping a risky product in an FD wrapper seems to be a manipulative way to attract Middle Class Indians .

Here’s why Middle Class Indians should avoid high interest yielding FDs from small Finance banks or Cooperative banks .

Why High Interest FDs Can Be Riskier Than They Appear

• Higher FD Rates Require Even Higher Loan Returns

If a bank offers higher FD interest rates, then it is bound to provide high interest loans to maintain profitability .By doing so , the bank would attract higher-risk borrowers who are likely to default on this loan .

So you would have also observed that these banks market and promote their FDs far more than their loans to hide the underlying risks. These small finance banks also offer loans more easily so that it is within reach of middle class borrowers who are in financial stress or in dire need of money without much documentation .

Small Finance banks charge around 25-26% interest on certain loans .

Also check out : 7 Credit Card Traps Every Middle-Class Indian Should Know

• High Concentration in Specific Lending Segments

Small finance banks or cooperative banks loan portfolios are pretty much concentrated in small businesses, self-employed borrowers , microfinance . With no other options , these groups opt for such types of loans despite having high interest .

These borrowers have weak financial power and survive because of such loans . A single event such as poor harvest , medical emergency and business slowdown due to tariff can severely impact their income , resulting in delayed payment or default .

They have heavy exposure of 45%- 75% in microfinance loan market .

• Lower Capacity to Absorb Large Losses

Many of these small finance banks and cooperative banks don’t have the capacity to absorb losses because of their smaller capital base and balance sheet . Provisions for these bad loans lead to reduction in profits and weakens capital position and stops the company from lending fresh credit . Until the losses persists , bank would need to curtail growth and dilute their shareholding to raise additional capital .

• Greater Dependence on Fixed Deposits

Many Small Finance Banks depend heavily on retail fixed deposits keep their company running . They offer only a few products other than FDs like –

• Small business loans
• Microfinance
• Affordable housing
• Vehicle loans
• Agriculture loans
• Small retail deposits

Unlike traditional large banks, these companies have lower CASA ratios ( Current account Savings account ) . So , once customers are no longer interested in the FDs any more , the companies would find it difficult to maintain growth in the future .

Also read : 4 Investment Mistakes Every Middle Class Indian Should Avoid

• Deposit Insurance Is Not the Same as Instant Liquidity

The bank deposits in India are insured up to 5 lakh rupees per bank under the Deposit Insurance and Credit Guarantee Corporation (DICGC) , but one should not do the mistake of confusing insurance with instant liquidity .

When a bank is kept under regulatory restrictions because of financial stress , the innocent depositors attracted by high interest payout FD would temporarily lose access to their money .

The delay in the payout of the insured amount is often uncertain because investigation , verification of depositors and resolution of the bank varies from case to case . So , the households or businesses that rely on these funds that are stuck may face significant financial and mental stress for an uncertain time period .

• ALM (Asset Liability Mismatch)

Banks have a basic mechanism to borrow money for shorter periods and lend money for a longer time periods. If the gap widens that means if reliance on short term FDs increases too much to finance loan , it leads to the creation of an Asset-Liability Mismatch .

As the FD maturity cycle continues , banks must replace them with new funds to sustain their loans. Hence , during interest hikes or declining customer’s trust , refinancing these loans would become extremely difficult and expensive . These factors would eventually lead to lower profitability and put a question mark on bank’s longevity .

Conclusion

Additional interest rate that we get from these small finance banks and cooperative banks is not for free , it has a cost which hidden from the customers. This is the price that these banks are willing to pay to attract the customer to its product .It is a relatively high- risk product which is wrapped in a FD wrapper .

This does not mean that every small finance bank or cooperative banks is unsafe . It means that never invest because the bank offers 1-3% higher interest rates, before investing always evaluate the bank’s fundamentals thoroughly .

Secondly , for a middle class Indian family , FD is not a tool to get enhanced returns over your investments . It is rather a tool to store your capital for emergency or a short term goal. Because whenever an emergency happens , preserving your capital should always take priority over earning extra interest on your money.