Monetary transmission remains a buzzword in policy setting. In the Indian context, transmission theory indicates that adjustments in RBI repo rate directly affect short-term money market rates, which may then transmit the policy impulse to the fuller spectrum of interest rates in the financial system, including deposit and lending rates; that, in turn, affects consumption, saving and investment decisions of economic agents. Thus, the interest rate channel of transmission has become the cornerstone of monetary policy in most countries, and India is no exception.
However, in India the interest rate channel has become blunt due to a number of issues that are well documented. In 2015, RBI slashed the policy repo rate by 75 bps (25 bps each on 3 occasions) Following such, a number of banks have lower their lending rate (base rate) in the range of 10-30 bps and deposits rates in different baskets in the range of 25-50 bps, to transmit the benefits to the customer.
Despite the decline in interest rate, the incremental credit growth in 2015-16 (from March 20 to June 12, 2015), is only at 1.8%. Deposit-growth languishes at a YTD of 2.7%. The real interest rate continues to remain positive, even as banks are not able to reduce the interest rate on deposits beyond a point. Also, with inflation on a downward trajectory, a lot of retail customers are hooking into term deposits. This leaves the banks in a critical situation, as their cost of deposits (CoD) is thus not reduced.
In this context, RBI recently advised banks on the possibility of calculating their base rate basis marginal cost of deposits/funds (CoD), rather than average CoD. The text book theory regarding relationship between marginal and average cost suggests that in a situation of declining (increasing) interest rates, marginal cost of deposits (MCD) will always be lower (higher) than the average cost of deposits. This will mean banks could charge lower (higher) lending rate under declining (increasing) interest rate regimes. While it may seem logical in terms of theoretical underpinnings, the crucial issue will be the seasonality in marginal deposit accretion resulting in loan pricing becoming significantly volatile.
In order to get a proper understanding of how calculation of MCD is impacted under declining and rising interest rate scenarios, we have created a hypothetical example. In this example we have created three interest rate scenarios—rising, falling and no change. Further, we have also added one more dimension—inflow and outflow of deposits during a particular period. As evident from the table, under rising interest rate scenario, MCD is higher (lower) than the initial interest rates (we can also call it Average Cost of Deposits, i.e., 8.50% in our example) since new deposits are raised on higher (lower) rates.
The bottomline is that banks are mobilising deposits at a fixed rate but deploying the funds at a variable rate.
Additionally, most of the deposits are in the 1-2 year bucket, but 60-70% funds are in the long-term one, with an average maturity period of 7-10 years. This puts the banks in a critical situation in managing their ALM position. In this context, RBI Governor has argued that to convert fixed rate deposits into flexible rate deposits, banks can use derivatives. One of the possible products would be interest rate swaps (IRS), where fixed obligations of banks can be easily converted into flexible one. In this way, both the assets and the liability of banks are in flexible format.
Logically, to use derivative in deposits is an excellent option for the banks in India. Globally, too, the market for IRS is quite huge (nominal outstanding of $381,028 billion as of December 2014), but in India it is in nascent stage.
However, it may take a long time to develop an IRS market in India. Some of the reasons being: first, the depth of IRS market in India is shallow and banks are not able to handle the huge deposits base of the banks. For instance, even if banks convert 10% of their time deposits, it would be around 7 lakh crore. Second, it will be difficult for banks to find out a suitable counter-party for such a huge swap agreement. The total volume of current IRS market in India is only about R28,000 crore. Hence, the demand from the banks’ side may be very high, but the supply will not be commensurate. Third, it will be prone to the fluctuations in interest rates and MTM loss/profit. Finally, the treatment of these swap is also a ticklish issue as derivatives are off-balance sheet items and the question arises of how these could be treated (say, in P&L account). Clearly, we may need to overcome many hurdles in our quest for such a market in India!
Tapas Parida and Sumit Jain contributed to this article
The author is chief economic advisor, State Bank of India. Views are personal