Reviving the lending appetite of banks is necessary to combat the slowing economy stretching to multiple sectors. According to the International Monetary Fund, “Sharp deceleration in manufacturing output and subdued farm sector activity pulled down India’s GDP growth to over six-year low of 5% in the April-June quarter of 2019-20”. The previous low was 4.3% in Q4 of FY13. The economy is now much weaker due to corporate and environmental regulatory uncertainty and lingering weaknesses in non-banking financial companies (NBFCs).
The second round of relief announced last week is to boost housing and export sectors. The earlier package, among others, was designed to bail out NBFCs, auto sector and for upfront capital infusion of Rs 70,000 crore in public sector banks to create more lending space in the near term. The road map to consolidate the PSU banks is meant to form a stronger network in the long-term. Looking to the state of the economy, it is high time banks ensured an accelerated flow of funds to the commercial sector to help them emerge from the shadows of the slowdown.
Floating Lending Rates
After persuading banks to ensure faster transmission of policy rates, the RBI has ultimately made it mandatory to link their new floating rate loans to personal/retail and micro small and medium enterprises to an external benchmark from October 1, 2019. Such a lending rate regime poses several challenges for banks to maintain equilibrium in pricing assets and liability products. While the borrowers may get some respite when the interest rates are on a downward curve, it will simultaneously lead to a reduction in deposit rates. Customers will earn less on their deposits and borrowers on their margins kept with banks in the form of fixed deposits.
Even before banks could move on to link floating lending rates to benchmark rates, many PSU banks started cutting their marginal cost of funds based lending rates (MCLR) in a bigger range of 15-25 basis points (bsp) after the RBI went for an unconventional steep repo rate cut by 35 bps taking it to a low of 5.4%. The MCLR lending rate system introduced in April 2016 has outlived its utility as it did not facilitate faster transmission of policy rates.
The long-term viability of floating lending rates linked to an external benchmark will ultimately depend on how quickly banks can align them with the cost of deposits. Many PSU banks are linking both lending and deposit rates with an external benchmark to ensure pricing equilibrium between lending and deposits rates. But this is only for select products and not across the board to ensure that deposits and lending rates move in tandem with the movement of benchmark rates.
The big impediment is the interest rates on fixed deposits. The loan assets when linked to an external benchmark gets re-priced downwards immediately but the fixed deposits continue at past rates till they mature and get re-priced only in the next cycle of renewal at new reduced deposit rates. In the intervening period, banks will have to bear the loss of interest income on account of continuing past cost of deposits while the reduced interest income on loans will shrink revenue streams impacting profitability.
Due to conventional urge to earn better interest on their savings, customers prefer to put larger sums in fixed deposits retaining smaller sums in savings accounts to meet immediate liquidity needs. As a result, the cost of deposits of banks depends on past deposit rates and not necessarily on present deposit rates.
Banks hardly draw 1-3% of their resources from the RBI through the repo route depending on their structure of assets and liabilities. PSU banks with low credit-deposit (CD) ratio of 68.96% in March 2018 have no scope to borrow from the repo route. They may invest their surplus funds in reverse repo with the RBI. Only private sector banks with a CD ratio of 88.36% may have some scope to borrow through the repo route. So, whenever the repo rate is cut, its impact on reducing the cost of a bank’s resources is nominal and does not add capacity to reduce lending rates in line with repo rates.
Hence, near-term sacrifice in interest earnings is causing concern to banks to move to link lending rates to an external benchmark. If they are mandated to do, they will have to explore other opportunities to offset such losses. One way is to reduce interest on savings deposits. But in a stiff competition for augmenting low-cost resources – savings and current account (CASA) deposits — banks cannot reduce interest on savings in a measure that could compensate the loss of interest earnings on loans. The second option is to recalibrate the risk premium to be loaded above the benchmark floating lending rates to compensate for the loss of earnings. This erosion in potential earnings is a genuine cause of hesitation to link lending rates to external benchmark.
The deposit data of March 2018 further substantiates this fear. Of the total deposits – the major part of bank’s resources — 58.9% deposits of PSU banks and 55.6% of private banks are in term deposits that are not impacted by revised lower term deposit rates be implemented now. Only incremental rise in term deposits and those due for renewal will be at lower interest rates. The rest is in savings and current deposits. Such large corpus of term deposits at old interest rates for a fixed term continues to keep interest payment obligations intact while earnings on loans will decline.
Interest rates are cyclical depending upon the macroeconomic state. When the interest rate cycle again reaches an ascending curve, banks will be in a favourable position in terms of the pricing equation. The loans will be repriced at new rates while the mass of fixed deposits will remain at low interest rates. In the long-term, banks will have a neutral situation.
Notwithstanding the low lending rate cycle, banks should speed up credit offtake while passing on the lower floating lending rates to trade and industry, at a time when the economy needs it the most. Hence, the present move of the RBI to mandate banks to link lending rates to an external benchmark is well thought-out to tackle the slowing economy. But it will depend on how banks will take an aggressive posture in lending to the commercial sector.
(The author is Director, National Institute of Banking Studies and Corporate Management, Noida)