Forcing banks to cut lending rates is a really bad idea
Having gone through a massive NPA crisis, which has cost taxpayers close to `15 lakh crore, banks today are a lot more cautious about how they use precious capital. If the flow of credit has slowed sharply over the past few months, it is because there aren’t too many credit-worthy borrowers; the sharp slowdown in the economy has left companies, especially smaller ones, in trouble. At a time like this, it is surprising the Reserve Bank of India (RBI) should be forcing banks to price retail loans—home and auto—and loans to MSMEs over an external benchmark. This could be the repo, the three-month or six-month treasury bill, or any other market benchmark interest rate published by Financial Benchmarks India Pvt Limited.
The move is ill-timed, and not just because interest rates—both the risk-free yield and the repo—are at relatively low levels, but also because the rate of growth of deposits is slow. Borrowers find it hard to cope when rates go up, and when the economy starts looking up, interest rates are bound to rise. Also, banks have been reducing the interest rates on deposits, but most of the cuts have already taken place, with not too much room for more. Indeed, from here on, the fall in deposit rates would be just slightly more than the fall in the repo.
But, more than 90% of banks’ resources are sourced from term and demand deposits, and a very small portion, of less than 5%, is raised from the repo market. Ideally, therefore, banks should price their loans over the weighted-average cost of funds. Also, the central bank should allow banks to offer floating rates on deposits, given the interest rate swap market is shallow. Given that the MCLR is higher than those on repo-linked instruments, if banks price their loans over an external benchmark, their margins are likely to suffer. In the current environment, where there are not too many good borrowers, banks will be unable to garner enough volumes to offset the lower pricing.
Although the spread can be raised only if there is a substantial change in the borrower’s credit assessment, banks might come up with ways to bill the borrower to compensate for the loss on the rate. It will not be easy, but they will try. Analysts point out that the base rate and the MCLR ultimately impacted net interest margins to a lesser extent than anticipated, and the transmission in the case of MCLR took almost two years. Banks may also opt for shorter-term deposits to be able to manage the interest rate cycle better. That will hurt savers. RBI may be frustrated that transmission isn’t faster, but forcing banks to lose out on their margins is simply not fair. This is a free market and banks must be allowed flexibility to price their loans.