The prospect of sharp reductions in interest rates by the end of the year is great news for borrowers. But what about the savers who have deposits in banks and building societies?
Small savers with demand accounts already get very low interest on their deposits and the smaller the amount on deposit the lower the interest paid. Customers also get lower interest rates in return for immediate access to their funds.
An Post is currently quoting 0.5 per cent for demand deposits up to £5,000 and 1 per cent on deposits of £5,000 and over. AIB offers 0.75 per cent on demand accounts up to £99,999.
When interest rates fall all savers will get even less and it is even possible that their banks or building societies could start to charge fees for minding their cash. The banks say they have no plans to introduce charges on savings accounts. But the US lead the way with such an initiative in the 1980s.
Most depositors in the US now pay a monthly administration fee to their banks for holding their savings. Charges vary widely from bank to bank and are related to the size of the account, the banking habits of the customer and the other business he/she has with the bank.
At First National Bank of Maryland, AIB's subsidiary in the US, depositors can get "credits" for using electronic banking (for example ATMs) rather than paper-based lodgements and withdrawals. The credits can be used to reduce the monthly charge.
The fall in interest rates here will reduce the income customers earn on deposits built up in banks and building societies. An added danger is that if inflation remains at current rates or increases, sums left on deposit at low interest rates could actually fall in value - that is, their purchasing power could be eroded.
For example, a sum of £5,000 on deposit at an interest rate of 2 per cent would have increased to £5,100 at the end of a year. But if inflation was, say, 3.5 per cent then something costing £5,000 now would rise to £5,175 in a year's time, so the real value of the depositor's lump sum would have fallen by £75. This is what economists mean when they talk about the real interest rate - it is the difference between the rate you are paid for your deposit and the rate of inflation. Where inflation is higher than the interest paid on a deposit, the deposit is losing buying power.
For many depositors the return on their small demand deposits is already in negative real interest rate territory - their savings are losing value. People keep such accounts for a variety of reasons, including the need to have ready access to cash, but many savers keep too much of their funds in demand accounts. Most ordinary demand accounts offer interest rates of under 1 per cent. But there are a range of variations on the ordinary demand account which offer better value to the customer. These place conditions on withdrawals but offer higher interest rates.
For example, the Bank of Ireland has a deposit account which restricts withdrawals to one per calendar month but pays 3.25 per cent on amounts up to £5,000.
Because rates are so low on small ordinary demand accounts there appears to be little scope for the financial institutions to cut the interest paid further. This is where charges could be introduced to discourage customers from holding large sums in demand accounts and carrying out a lot of small transactions. Banks maintain that they make no money now on small demand accounts, arguing that the low interest paid reflects the high cost of administration involved and the absence of charges. One banking source suggested that some institutions could stop taking small demand deposits as interest rates fall.
While there is little scope for cuts in rates on small demand deposits, interest rates are expected to come down sharply on the range of semi-demand deposit accounts including the low DIRT-rate Special Savings Accounts. For the financial institutions the imminent reductions in interest rates is a major strategic problem. As interest rates fall their margins, or profits, on core lending and funding operations are squeezed.
Broadly, margins comprise the difference between what a bank charges for loans and what it pays for funds. As interest rates fall in a competitive banking market financial institutions should be forced to pass on much of the fall in market rates to borrowers but may be unable to cut the rates offered to depositors to the same extent. Thus margins get squeezed. For financial institutions who have to report to shareholders, the dilemma is how to maintain profit levels. There is some scope in developing new savings and lending products, reducing costs by encouraging customers to move from demand accounts which have high administration costs to fixed accounts and to use electronic rather than paper/counter-based transactions. Some banks and building societies may decide to bring in charges on some savings accounts. But in a competitive market strong customer resistance could be expected.
For savers with demand accounts who are anxious to avoid risk there are alternative ways to generate better returns.
Examining their deposits and their cash needs to assess just how much they need to keep on demand must be the first step. The aim should be to keep this amount as low as possible - it generates the worst rate of interest return.
Next, savers who do not wish to take risks with their money should move the rest of their savings into other deposit products and quasi-deposit products. Fixed period deposits, where funds must be left for a fixed period with no withdrawals (or just a few) allowed, or savings products where the capital sum is guaranteed and the return is linked to equity or bond market performance, can provide better returns than demand accounts.
