Banks Caught In A Trap

The cost of deposits is on the rise, but banks can't raise interest rate on close to 60% of their loan books, points out Tamal Bandyopadhyay.

The earnings season is over. Barring a few, most listed banks have recorded handsome net profits in the June quarter of the current financial year.

Their combined net profit has risen 21.04 per cent on a year-on-year basis. For a few banks, bad loans as a percentage of total loans have risen, but that's not alarming.

What are the two most critical parameters of banks' earnings that give us a clue as to how long the good run will continue?

So far, all eyes had been on credit cost: The movement of bad loans and the provision coverage or how much a bank sets aside to take care of such loans.

Higher provision, coupled with recovery, brings down the pile of net bad loans and adds muscle to a bank's balance sheet.

The focus should now shift to the cost of deposits and the net interest margin (NIM), loosely the difference between what a bank spends on deposits and what it earns on loans.

Bandhan Bank Ltd had the highest NIM in the June quarter at 7.6 per cent, followed by IDFC First Bank Ltd (6.22 per cent) and RBL Bank Ltd (5.67 per cent).

On the other end of the spectrum are Jammu & Kashmir Bank Ltd (0.96 per cent), Yes Bank Ltd (2.4 per cent) and Punjab & Sind Bank (2.69 per cent).

For most banks, the NIM was compressed in the June quarter compared with the year-ago period, and even the previous quarter.

For a few of them, the drop is very sharp. For instance, IDBI Bank Ltd's NIM dropped to 4.18 per cent in the June quarter from 4.91 per cent in the quarter ended March.

In April-June last year, its NIM was 5.8 per cent. Catholic Syrian Bank Ltd's NIM dropped from 5.04 per cent to 4.36 per cent; for Indian Overseas Bank, the drop was from 3.53 per cent to 3.05 per cent. All in one quarter.

Isn't that surprising when most banks are chasing retail assets? Typically, the yield or return from retail loans is higher than corporate loans. There's a catch; I will come to that later.

Let's take a look at how banks' costs are rising. Barring one bank (Karur Vysya Bank Ltd), all banks have recorded lower current and savings accounts (Casa) piles in the June quarter.

For a few banks, the drop in Casa in the March quarter is very sharp. For instance, Bandhan Bank's Casa dropped from 37.1 per cent in March to 33.4 per cent in June.

The comparable figures for Bank of Maharashtra were 49.86 per cent (from 52.73 per cent), IDBI Bank 48.57 per cent (from 50.43 per cent) and Catholic Syrian Bank 24.9 per cent (from 27.2 per cent).

The percentage of Casa of total deposits for Karur Vysya Bank inched up in the June quarter to 30.37 per cent from 30 per cent in March, but less than the 33 per cent in the June quarter the previous year.

Casa is the proverbial bread-and-butter liability business for banks as they get cheap money through this route.

The savings bank rate was deregulated in 2011, but most banks offer very low interest.

The money kept in the current account does not earn any interest. So, the higher the Casa, the lower the cost of money for banks, and the higher the NIM.

As a fierce war continues for deposits, the banks' cost of money is rising. Ideally, the cost of loans for borrowers should also rise. But that's not happening. Banks are caught in a trap.

Look at these figures: The weighted average lending rate (WALR) on fresh rupee loans of all commercial banks was 9.39 per cent in May, down from 9.55 per cent in April.

The WALR on outstanding rupee loans remained unchanged at 9.83 per cent in May. The weighted average domestic term deposit rate on fresh deposits remained almost unchanged at 6.47 per cent in May (against 6.48 per cent in April), but the weighted average domestic term deposit rate on outstanding deposits rose to 6.93 per cent in May (from 6.91 per cent in April).

What do these figures say? The cost of deposits is on the rise, but the earnings on loans are either falling or remaining the same.

Simply put, banks are not able to pass on the higher cost of deposits to their borrowers.

Why? They are trapped!

Look at the composition of bank loans. In March, the share of external benchmark-based lending rate (EBLR)-linked loans in total outstanding floating-rate rupee loans of banks was 57.5 per cent, up from 56.9 per cent in December 2023.

The component of marginal cost of funds-based lending rate or MCLR in March was 38.3 per cent, marginally down from 38.8 per cent in December.

These two don't add up to 100 per cent; the rest of the loans are linked to the base rate and banks' benchmark prime lending rate (BPLR); there are fixed-rate loans too.

Neither of the first two sets is in vogue now; the loans attached to these two benchmarks are legacy loans.

The base rate was introduced in July 2010 with an understanding that no bank would lend below its base rate.

Before BPLR, there was PLR or prime lending rate, introduced in October 1994.

It was the rate at which banks used to lend to their top-rated clients and it had no relation to their cost of funds. Sometime early this century, RBI replaced PLR with BPLR.

Introduced in December 2019, EBLR-linked loans are given to all micro, small and medium enterprises (MSMEs) as well as retail loans.

The banks primarily use the repo rate and, for some products, the 364-day Treasury Bill rate as an external benchmark.

The last time the repo rate was raised was in February 2022; it has remained unchanged since then.

During this period, the yield on 364-day Treasury Bills has dropped from 7.0628 per cent to 6.7240 per cent.

This means, banks cannot raise the loan rates linked to EBLR even though their cost of money has been going up.

In a rising interest scenario, they used to raise their loan rate immediately after each time the repo rate was raised.

MCLR was introduced in April 2016, replacing the base rate. It takes into account the marginal cost or the rate offered on new deposits.

MCLR was introduced to bring in more transparency and make lending rates more responsive to the central bank's policy rate changes.

Banks do change the MCLR every month. They are required to reset the EBLR at least once a quarter.

For MCLR, banks calculate their marginal cost of funds across maturities of deposits.

They also add the so-called negative carry on cash reserve ratio (the portion of deposits that banks keep with the RBI on which they don't earn any interest), operating cost and a tenure premium for the risk associated -- the longer the tenure, the higher the risk. The final loan rate is decided on the spread over the MCLR that banks charge.

No bank is allowed to price a loan below MCLR and the spread over MCLR can widen if the risk profile of a borrower deteriorates.

Of course, fixed-rate loans can be given below MCLR -- something banks had indulged in when BPLR was in vogue.

Traditionally, banks have been faster in raising their loan rates when the policy rate goes up, but not so prompt in paring rates when it goes down.

This is because they can cut their loan rates only after paring their deposit rates, but that cannot happen overnight as the lower rates are applicable to only the new deposits, while old deposits continue to cost more.

Now, the wheel has turned. Banks have no choice but to offer higher rates to attract deposits, but they cannot pass on the burden to borrowers whose loans are linked to EBLR.

They need to take the hit. This will continue as the policy rate will go down at some point, but banks will not be able to cut the deposit rates till the war for deposits is over.

This is a new paradigm in the Indian banking industry.

Tamal Bandyopadhyay is an author and senior advisor to the Jana Small Finance Bank Ltd. His latest book is Roller Coaster: An Affair with Banking.

Disclaimer: These are Tamal Bandyopadhyay's personal views.

Feature Presentation: Rajesh Alva/Rediff.com