When interest rates are high, fixed deposits become more appealing to investors. Being secure financial instruments, they offer predictable returns, making them a great choice for those with a low-risk appetite.

s the Reserve Bank of India (RBI) steadily raised the repo rate, FDs became an even more attractive investment option, delivering returns north of 9% in some schemes. However, there is so much variability in FD interest rates, and small commercial banks typically outpace larger banks in terms of interest offered.

But why do small commercial banks offer higher rates, and is it a safe strategy to chase these returns?

• Small finance banks often provide higher interest rates to attract customers.
• Investors should weigh higher returns against potential risks in small commercial banks.
• Large commercial banks tend to offer more stability but lower interest rates.
• Awareness of deposit insurance can help mitigate concerns about bank reliability.

It is often observed that small commercial banks tend to provide higher interest rates than their larger, more established competitors. Why? Because these smaller banks have an incentive to draw customers by offering competitive rates, especially since they are relatively new players in the market.

The difference in interest rates is not insignificant. While larger banks like HDFC Bank or Union Bank of India may offer between 6.5% and 7.45% for fixed deposits, small finance banks such as Unity Small Finance Bank or North East Small Finance Bank have offered up to 9% on FDs​.

The higher interest rates serve as a dual strategy for growing the customer base and attracting deposits. Smaller banks typically have less capital. That is why they rely more on these deposits to lend to sectors like small businesses or underserved communities. Consequently, they need to offer more competitive rates to entice investors who would otherwise choose a larger, more established bank. If you are looking for a safe investment option, you can consider fixed deposit. They offer guaranteed returns and a fixed interest rate throughout your investment tenure.

Although small commercial banks offer tempting interest rates, there are some challenges and risks that potential investors experience:

Perception of risk

One of the biggest concerns is how customers perceive the stability of small finance banks. Most often hesitate to place their funds in these banks because of concerns about their financial health, longevity, and trustworthiness.

Even despite these apprehensions, it is worth noting that deposits in such banks are insured by the Deposit Insurance and Credit Guarantee Corporation for up to Rs. 5 lakhs. This level of protection is comparable to that against any large commercial bank. But the fear of collapse persists, especially with newer or lesser-known players.

Lack of awareness

Many investors are simply unaware of the higher returns offered by small finance banks. This is partly because these banks have smaller marketing budgets and limited geographic presence compared to larger commercial banks. As a result, investors miss out on potentially better interest rates due to a lack of information.

Branch accessibility

Accessibility can also limit some investors from being able to put their funds in the schemes offered by small finance banks. This is because such institutions generally have fewer branches. Their locations may not be as convenient for customers in rural or suburban areas. While online banking solutions can mitigate this issue, customers still prefer face-to-face interactions, as they offer a greater degree of trust in the institution for some.

The difference between the rates offered by small finance banks and larger commercial banks is quite stark. For example, Unity Small Finance Bank offers an interest rate of 9% for general investors in investments longer than 1,001 days. This rate goes up to 9.50% for senior citizens​.

Similarly, North East Small Finance Bank offers comparable rates, with its FD products yielding 9% for tenures between 546 and 1111 days​.

Other small banks, like Suryoday Small Finance Bank and Shivalik Small Finance Bank, offer similarly competitive rates, ranging from 8.55% to 8.65%, depending on the tenure​.

In contrast, large banks like HDFC Bank and Union Bank of India offer lower interest rates for similar periods. HDFC Bank’s highest rate stands at 7.40% for a five-year FD, while Union Bank’s best offering is 7.40% for 333 days​.

Even the Central Bank of India, which leads among public sector banks, offers a maximum of 7.45%​.

This goes on to show how much higher small finance banks are willing to go to attract deposits, offering an opportunity for higher returns.

Although these rates can be tempting, it is important to know the potential trade-offs. Small finance banks typically lend to riskier segments like MSMEs. This means that they face higher default rates compared to larger banks. This, in turn, might pose liquidity issues for the bank.

However, it is also worth noting that these banks operate under strict regulatory oversight of the RBI. Investors with deposits of up to Rs. 5 lakhs are also covered by the DICGC insurance scheme. This level of assurance offers a safety net, but when making deposits exceeding Rs. 5 lakhs, one must carefully monitor the quarterly performance of the bank along with their overall financial health.