Linking loan-rates to repo-like rate simply won’t work

Surely RBI Governor knows banks can’t re-price loans at will; and banks will just raise spreads if RBI forces them

loan rate, repo rate, RBI, Shaktikanta Das, financial express editorial, financial express, PSU bank, MCLR
A little over a third of bank funds are got from savings deposits, so it is vital these get re-priced immediately.

Given how so many economists, along with those in the government, believe than an interest rate cut is the silver bullet the flagging economy needs, it is not surprising that, with RBI having cut repo rates by 85bps since February, Governor Shaktikanta Das is once again talking of the need to speed up transmission; banks have cut lending rates by around less than half this amount. At the Fibac conference on Monday, the Governor spoke of the possibility of speeding up transmission by formally linking lending rates with an external benchmark like the repo rate. While the government will welcome such a move, it is a bad idea and simply won’t work.

For banks to remain profitable while cutting lending rates, they need to be able to borrow at rates that fall in tandem with the repo rate, or whichever external benchmark the RBI finally zeroes in on. A little over a third of bank funds are got from savings deposits, so it is vital these get re-priced immediately. Given how much pressure the political class put to get banks to raise savings deposit rates to where they are today, will the government allow banks to link savings deposit rates to the repo? Or will the government argue that small savers—and this includes millions of retired people—need to be protected from the vagaries of the market? Certainly, by not reducing interest rates on small savings, the latter would appear to be the government’s view. In which case, it is unfair to ask banks to cut lending rates immediately while they continue to pay the same rate to their depositors.

Another 30-35% of bank funds come from bulk deposits, which are funds that large corporates, among others, deposit with banks or other bodies to earn interest on till they need them; since interest rates on these are unregulated and there is enough competition to get them, the rates on these bulk deposits are typically higher than even those on fixed deposits at most times. As for the repo rates that RBI cuts, or raises, just 2-3% of bank borrowing—even less at most times—comes from the central bank; the repo applies to these loans. In other words, most of the money that banks have, and use to give loans, is borrowed at interest rates that are fixed. If banks are then forced to cut lending rates, their losses will soar.

Cutting into bank profits is a bad idea at most times, but it is least desirable at a time when, as now, banks are desperately trying to shore up their balance sheets; ironically, if PSU banks make losses by being forced to cut lending rates even as their borrowing rates remain broadly unchanged, the government will have to make good these losses. Banks can, of course, lower lending rates by reducing their spreads; but this is not easy since the spread is determined by, among other factors, the size of their work force, which cannot be reduced in even the medium-term for PSU banks, the costs of maintaining an expensive legacy branch network, etc. What is more likely, should the central bank force their hand by going ahead with the linking, is that banks will just increase the spread between the repo-linked MCLR rate and the one charged to lenders; once this is done, even if the MCLR falls, the lending rate will remain the same. A better course for RBI is to encourage banks to link some loan products—some banks have done this for home loans recently—to the repo, but not to insist on an across-the-board linkage.

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