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External benchmarks for loan pricing puts cart before the horse

After four failed attempts and years of moral suasion to ensure its interest rate actions ripple through the banking system and financial markets, the Reserve Bank of India last week ordered banks to link some of their lending rates to benchmark rates. That was just four days after deputy governor BP Kanungo described fixed income and derivatives markets as ‘moribund,’ ‘lacklustre,’ ‘stunted’ and that a robust ‘term money market eludes us.’ Moving floating interest rate loans of home buyers and small and medium enterprises would push the lenders, borrowers and the regulator itself into un-chartered territories where the outcome could be different than what the regulator aspires for.

A sudden squeeze on profitability of banks, volatile returns for many of the savers who still rely on bank fixed deposits for their monthly spends, and borrowers who could swing between surplus and deficit in their disposable incomes may become the new reality.

The absence of a liquid money market despite years of halfhearted attempts and the rigidities of administered rates could cripple banks.

“Repo is a terrible benchmark to use for a variety of reasons, you don’t get to know what the term premium is and when you lend at repo plus credit spread, you are taking overnight rate plus a credit spread and you are completely ignoring the term premium,” said Ananth Narayan, associate professor (finance), SPJIMR.

On September 4, the RBI, which postponed the implementation of the same scheme citing difficulties, said banks beginning October 1 should link their floating retail loans and MSME loans with either the repo rate, the rate at which it lends to banks, or with three, six-month rates of Treasury Bills.

The central bank’s move follows banks dodging to reduce interest rates for retail borrowers and small companies when it reduced rates, but move quickly to raise borrowing costs whenever it (RBI) raised rates.

POOR TRANSMISSION
Banks did not automatically raise or cut lending rates whenever RBI did so with its repo rate, leading to what the regulator termed ‘poor transmission.’ But banks’ cost of funds was not the repo rate, but what it paid for deposits and banks could borrow a limited 0.25 per cent of their deposits through the repo window. Even governors, who swore more by markets than by regulatory diktats, blamed banks.

“Earlier, some bankers had said that it was the lack of liquidity that was holding rates high, now I hear from some that it is the fear of FCNR redemption that is making them reluctant to cut rates,” said Raghuram Rajan in August 2016. “I have a suspicion that some new concern will crop up once the redemption is behind us.”

When RBI cut repo rate by 2 percentage points between December 2014 and August 2017, the average lending rate on fresh rupee loans declined by 193 basis points, RBI data shows. A significant part or 96-basis points cut occurred postdemonetisation. A basis point is 0.01 percentage point. Between April 1, 2016 and October 2016, the marginal cost of lending rate (MCLR) fell 15 basis points when repo was cut by half a percentage point.

Since Shaktikanta Das took charge as governor last year, the Monetary Policy Committee has cut repo rate by 110 basis points, but the banks have passed on just 49 basis points as relief. This at a time when the government is anxious to push credit and revive demand.

“Today, the economy requires a certain amount of push not just from the monetary policy but also from its transmission, our expectation is that they (banks) should move faster,” Das had said.

Although central bankers may have to worry about the effectiveness of their policy, it could be an unnecessary hindrance in the way banks conduct their business in a market environment.

“In my view, there should not be any regulation around it...it is my assetliability management, let me decide,” says Rajnish Kumar, chairman, State Bank of India. “Worldwide, nobody regulates the interest rate or gives a formula. What they care about is disclosure. We are the only economy which has a prescription despite a deregulated interest environment. This should not be prescriptive, competition will take care of the pricing.”

DISADVANTAGE FOR BANKS
Oftentimes markets lead the monetary policy decisions. While mutual funds and investment banks can react to rate decisions and pass on to their investors, commercial banks with five to ten-year deposits from retirees can’t do so.

“Fall in rates will depend on each bank’s asset-liability position, on the liability side how much variable ratelinked deposits they can get,” said Rajnish Kumar. “We have to understand that especially senior citizens, pensioners depend upon income from fixed deposits and may not understand the inflation differential. If a customer has a Rs 10-lakh deposit and earned Rs 80,000 as interest, which today is down at Rs 60,000, it is a fall of nearly 25 per cent. You can explain the inflation differential but that is not how a common earner looks at it.”

Repo rate, which was 6.5 per cent in February, is now the lowest in a decade at 5.4 per cent. The 3-month T-bill rate has seen a drop of 100 bps since February and it’s currently at 5.4 per cent and the 6-month T-bill rate, which was at 6.4 per cent in February, is now at 5.5 per cent.

“Now everyone has to move to a system that will be more volatile. It remains to be seen how effective will it be because changing a 20-year home loan every three months, when rates are going higher, will have its own challenges for borrowers as well as regulators,” said Ashish Parthasarthy, treasurer at HDFC Bank.

As banks struggle to match their liabilities and assets to keep their profits, there could be an erosion in the near term.

“This will put pressure on yields and margins for the banks in a declining interest rate scenario, as they will be forced to transmit rates faster while the transmission on deposit rates will still happen with a lag,” says Adarsh Parasrampuria, analyst at Nomura Securities. Banks have 20-40 per cent of their loans as on FY19 in the mortgage/SME/ business banking segments, where the new pricing regime may get implemented. The impact on corporate banks will be more significant.”

Furthermore, banks face competition from mutual funds, which have tax advantages, and have to meet many regulatory diktat like priority sector lending. With nearly half their deposits in the one year tenor and 20 per cent above five years, banks are exposed to rate risks which they cannot hedge in a derivative market that’s ‘lacklustre’ and ‘moribund.’ Small savings such as Public Provident Fund and Kisan Vikas Patra offer 135-basis points higher rates than SBI’s three-year deposit rates and they are a big draw for retail depositors. Interest rates on these are supposed to be reset every quarter based on government bond yields, but that has been erratic.

“Banks are certainly competing with small savings rates. For any typical depositor, there is a choice between putting their money in small savings instruments or bank deposits,” said Indira Rajaraman, a former member on the board of the Reserve Bank of India and the 13th Finance Commission. “If small savings deposits are directly competing with you and they are set against the G-sec, which is already at the upper end of the term spectrum, then that will certainly limit banks ability to reduce their deposit rates.”

Loans snip 1

POLICY & SHOCKS
Linking retail loans with the repo rate may bring with it other unintended consequences in the form of limiting policy actions and shocks to borrowers who can’t really figure their liabilities.

“The last policy action was an outlier with a cut of 35 basis points... such large changes in the repo rate may cause increased volatility in the EMIs for the borrowers, which may pose hardship during the rate hike cycles,” said Anil Gupta, co-head of financial sector ratings, ICRA.

A back-of-the-envelope calculation shows that a 50-basis points rise in repo rate leads to Rs 2,200 increase in monthly payments on a Rs 75 lakh-loan payable over 15 years. A 100-basis points climb could pinch the pocket as much as Rs 4,500 a month. If 110-basis points cut could happen in less than a year, it could happen on the way up too.

While the MPC has an inflation target of 4 per cent with an option to move in the range of 2 percentage points on either side, the social consequences of a warranted steep hike like in 2013 to limit a crisis may not be easy to come by.

“We expect the future monetary policy actions may be asymmetric, with a relatively lower increment during the rate hike cycles and frontloading during rate cuts,” says ICRA’s Gupta.

But economist Rajaraman believes that MPC wouldn’t be constrained by the likely impact on retail borrowers and would concentrate on its target. But she says that forcing banks to link rates may not be the best policy option.

“I think that this kind of mandatory links should not be imposed by the RBI, you have to let the market work out the competition between banks,” says Rajaraman. “Other things being equal, if I want to borrow and Bank of Baroda is offering me a lower rate, I am going to gravitate towards them. If a bank doesn’t move with the market, they will lose out on market share and good borrowers.”

With a rigid small savings rate, the absence of derivative markets to hedge and lack of level playing field with rival structures such as mutual funds, the RBI may well have put the cart before the horse.
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