Indian banking business just got more complex

'Rating agency Moody’s Investor Services has already warned that the move would be credit negative for banks, causing volatility in net interest margins.

'One of the key changes that banks may have to make is how they price their deposits,' says Joydeep Ghosh.

Illustration: Uttam Ghosh/Rediff.com

The Reserve Bank of India’s (RBI’s) decision to link all floating rate retail loans and micro, small and medium-scale enterprises (MSMEs) from October 1 comes after several attempts in the past - from prime lending rate to marginal cost of funds (MCLR) - to ensure smooth transmission of interest rates cuts failed.

Now, all banks have to link the lending rates to one of these four - the RBI policy repo rate, government of India three- or six- month Treasury bill yields or any other benchmark market interest rate published by the Financial Benchmarks India (FBIL).

How workable is this proposal?

Says Madan Sabnavis, chief economist, Care Ratings: “From a regulatory perspective it is an ideal way to ensure that transmission of repo rate changes takes place on the lending side.

"However, there was an anomaly the last time when the RBI lowered the repo rate to 5.4 per cent.

"One indicator, the 10-year Government Security (G-Sec), if it had been used as a benchmark, would have gone contrary to the direction of the repo rate change as it has increased over the two month period by 20-30 basis points (bps).”

Sabnavi says banks are likely to face a tough time from a commercial banking perspective as they have to benchmark a part of their assets to an anchor while not being allowed to do so on the liabilities’ side.

Rating agency Moody’s Investor Services has already warned that the move would be credit negative for banks, causing volatility in net interest margins (NIMs).

“With NIMs rising when interest rates rise and falling when rates fall, the move will translate into volatility in the overall profitability of banks.

"It is not clear if banks will be able to mitigate this risk by linking the interest rates on current account, savings account (or CASA) deposits to an external benchmark. With interest rates already low on these deposits, a bank is unlikely to want them any lower as it will risk losing customers.”

Former RBI Deputy Governor and Chairperson of FBIL, Usha Thorat says: “Currently, banks price loans based largely on the cost of their deposits.

"CASA constitutes about 40 per cent of their liabilities and are not interest rate sensitive.

"Fixed deposits constitute about 50-70 per cent.

"The average maturity of these deposits is between one year and 18 months.

"Hence, to manage their asset-liability management (ALM), banks prefer to link loan rates to their deposit rates on fixed deposits to keep their NIM stable.”

According to Thorat, the one-year deposit rates of banks is closely correlated to some FBIL benchmarks – the 364-day T Bill rate or one-year G-Sec yield or even the one-year OIS (overnight index swap) rate.

“Hence, banks could link their floating rate loans to an appropriate one-year benchmark to manage the asset-liability mismatch.

"The three-month reset specified by the RBI could, however, pose challenges and it may be better to leave the choice of reset to the individual banks.

"Some banks may have concentration of liabilities in the five- year segment and may prefer to reset their floating rate interests at longer intervals - as, I believe, State Bank of India (SBI) is asking for,” Thorat adds.

The backstory

In fact, the implementation of this rule has been delayed by a good six months.

In December 2018, under former RBI Governor Urjit Patel, it had been mandated that the shift would take place from April 1, 2019.

The decision came after a rather damning report by the central bank’s internal committee led by Janak Raj.

The committee studied four major banks (two public and two private) and found that one major public sector bank decided on the MCLR rate, based on card rates of retail term deposits of seven days to one year.

It fully ignored the cheaper resources collected under CASA.

In the case of private banks, some even flouted apex bank guidelines by having multiple rates instead of one MCLR across products.

This was done by using different operating costs for different loan products.

Patel’s abrupt resignation came as a partial relief for banks.

In April’s Monetary Policy, the central bank stated that “further consultations will be held with stakeholders to work out an effective mechanism for transmission of rates”.

Then came the economic slowdown.

And the Finance Minister and Prime Minister started asking banks to pass on rate cut benefits.

After all, since Shaktikanta Das took over in January, the repo rate had been cut by 110 basis points.

But there were not significant cuts from banks.

The RBI finally bit the bullet earlier last month.

The way forward

One of the key changes that banks may have to make is how they price their deposits.

Floating rate deposit rates are ideal, but with rates on some products of National Savings Schemes as high as 8.6 (Sukanya Samridhi Yojana), they fear losing depositors in bank fixed deposits.

The State Bank of India and 14 other public sector banks have already announced products linked to the repo rate.

In the SBI's home loan product, the loan amount will be divided equally across the tenure, and the equated monthly instalment will be high initially and reduce as the number of years increase.

But the key would be spreads.

“It will be an interesting development for banks as they have to carefully choose their spreads over the chosen benchmark as this cannot change for three years,” says Sabnavis.

He offers an example.

If on October 1, a bank benchmarks home loans to, say, 200 bps over the repo rate of 5.4 per cent, the basic lending rate would be 7.4 per cent.

Now, in the first week of October, if the RBI lowers the rate by say 25 bps, the lending rate would automatically come down to 7.15 per cent and there would be a hit on the books.

“Therefore, arriving at the right spread to protect the profit and loss account will be critical for banks and they also have to anticipate how many more rate cuts would be there during the year while fixing the same,” adds Sabnavis.

In other words, the Indian banking business just got more complex.