FCNR bounty may spark bank lending rate war

With credit demand unlikely to immediately absorb the massive inflows, banks are also temporarily parking surplus funds in short-term government securities and high-quality corporate bonds, where relatively attractive yields are offering a profitable holding avenue. 

“I do expect banks to start lending a little bit more aggressively. Credit offtake has been reasonably strong as of now. But will excess liquidity have an overhang on interest rates? The answer is yes,” said a senior official at a private sector bank. “There will definitely be a little bit of a price war. I do see that happening,” the banker added.

Buoyed by the FCNR (B) deposits, the system liquidity hit a record Rs 11.16 lakh crore as of September 6. Liquidity has since moderated following the Reserve Bank of India’s bond sales and tax-related outflows, and stood at Rs 4.44 lakh crore as of September 22.

The sheer size of the inflows means banks will take time to deploy the money through loans. State Bank of India Chairman C S Setty recently said it could take at least three to four months for the banking system to absorb the funds.

On the sidelines of the SBI Banking & Economics Conclave, Reserve Bank of India Deputy Governor Rohit Jain said that the credit demand is broad-based, with all sectors and segments growing reasonably well, and the central bank does not see any particular sector requiring caution at present. 

“Banks are themselves cautious on credit and underwriting, and the RBI expects healthy credit standards to continue,” the deputy governor said. He added that the asset-liability position will determine how banks use the additional liquidity.

Bankers said the abundance of liquidity could intensify competition, particularly for highly rated corporate borrowers. Banks sitting on surplus funds have an incentive to sacrifice some lending spreads rather than leave the money under-deployed, potentially putting pressure on loan pricing across the system.

Even before the full impact shows up in lending rates, the FCNR(B) inflows are changing banks’ funding strategies. A senior official at a public sector bank said the funds would be substantially deployed by the third quarter or early in the fourth quarter. Apart from lending, banks are using the money to repay costly liabilities and are unlikely to tap the CD market aggressively over the next few months.

The impact is already visible in money-market rates. The three-month CD rate has plunged to 6.06% in September from 7.64% in May, according to Bloomberg data. CD issuances fell to Rs 68,130 crore in August, the lowest in four months, according to Primedatabase.

Replacing high-cost wholesale deposits with FCNR(B) money also gives banks greater room to compete on lending rates without taking as large a hit on margins.

Until lending catches up, banks are deploying part of the surplus in short-dated government securities and corporate bonds.

“Liquidity is increasingly being deployed across a range of short-term avenues as market participants seek places to park excess funds. We have invested in high-quality corporate bonds with maturities of up to three years, where yields remain attractive. We are also parking funds with mutual funds,” said a treasury official at a public sector bank.

The yield differential makes corporate bonds particularly attractive. PSU bonds in the two-to-three-year segment are offering yields of over 7.60%. Three-year AAA-rated corporate bonds are trading at around 7.74%, according to Bloomberg, compared with about 6.64% for government securities of similar maturity.

Another treasury head at a private sector bank said lenders with surplus liquidity have a clear preference for high-quality corporate bonds, although internal and regulatory exposure limits restrict how much they can invest.

“Banks must operate within prescribed limits — investment policies cap exposure to each category, so they cannot load up on corporate bonds,” the banker said.

Foreign banks, which have fewer domestic lending avenues than Indian banks, have also stepped up investments in government securities and corporate bonds to deploy the additional liquidity, market participants said.

But the bond purchases are essentially a parking space. As banks progressively shift the FCNR(B) funds from securities into loans over the next few months, the bigger impact could be felt in the credit market — with lenders competing more aggressively on price to put their liquidity to work.