The Reserve Bank of India has made it mandatory for banks to link all new floating-rate personal, retail loans, along with loans to micro, small and medium enterprises to an external benchmark-based interest rate from 1 October 2019. In this post, K. Srinivasa Rao discusses the viability of the move, along with challenges and opportunities that banks would face.
After persuading banks to ensure faster transmission of policy rates, Reserve Bank of India (RBI) ultimately made it mandatory for banks to link all new floating-rate personal, retail loans along with loans to micro, small, and medium enterprises (MSMEs) to an external benchmark-based interest rate from 1 October 2019. Such lending rate regime poses several challenges for banks to maintain equilibrium in pricing assets and liability products. While the borrowers may get some respite when the interest rates are on downward curve, it will simultaneously lead to reduction of deposit rates. Customers will earn less on their deposits and borrowers on their margins kept with banks in the form of fixed deposits. The policy move will also open up innovative opportunities for banks to explore new business, break past conventions, and adopt para-banking activities, and non-fund based products and services in a big way to compensate for the fall in interest earnings.
Before banks move on to link floating lending rates to benchmark rates, many public sector banks (PSBs) have already started cutting their marginal cost of funds-based lending rates (MCLR) in bigger range of 15-25 basis points (bps), after RBI had gone for an unconventional steep repo rate cut by 35 bps taking down repo rate to a low of 5.4%. MCLR lending rate system introduced in April 2016 was intended to remove the anomaly in pricing loan products linked to incremental variations in the cost of deposits. But MCLR too did not facilitate faster transmission of policy rates leading to the present move to link floating lending rates to external benchmark.
The long-term viability of floating lending rates linked to external benchmark will ultimately depend on how quickly banks can align them with the cost of deposits. In order to ensure such pricing equilibrium between lending and deposits rates, many PSBs are linking both lending and deposit rates with external benchmark – that too, only for select products and not across the board – to ensure that deposits and lending rates move in tandem with the movement of benchmark rates.
The daunting impediment for banks is the cost of fixed deposits that are fixed for the duration of the deposit period. The loan assets get repriced immediately but the fixed deposits continue at past rates till they mature and get repriced only in next cycle of renewal, at new reduced interest rates. In the intervening period, banks will have to bear the loss of interest income on account of continuing past cost of deposits while the reduced interest income on loans will shrink revenue streams impacting profitability. Due to conventional urge to earn better interest on their savings, the bank customers have a preference to put larger sums in fixed deposits retaining smaller sums in savings accounts to meet immediate liquidity needs. As a result, the cost of deposits of banks depends on past deposit rates and not necessarily on present deposit rates.
Banks hardly draw 1-3% of their resources from RBI through repo route depending on their structure of assets and liabilities. Public sector banks (PSBs) with credit-deposit (C-D) ratio of 68.96% in March 2018 have no scope to borrow from repo route. They may invest their surplus funds in reverse repo with RBI. Only private sector banks with C-D ratio of 88.36 may have some scope to borrow through repo route. Hence, whenever repo rate is cut, its impact on reducing cost of bank’s resources is nominal, and does not add capacity to reduce lending rates in line with repo rates.
Hence, near-term sacrifice in interest earnings is causing concern to banks in the move to link lending rates to external benchmark. If they are mandated to do, they will have to explore other opportunities to offset such loss. One way is to reduce interest on savings deposits. But in stiff competition for augmenting low cost resources – savings and current account (CASA) deposits – banks cannot reduce interest on savings in a measure that could compensate the loss of interest earnings on loans. The second option is to recalibrate risk premium factor (linked to the credit rating of the borrower) to load interest over and above the benchmark to compensate the loss of earnings. Many economists are apprehending such a desperate move to protect margins. Hence, the erosion in potential earnings is the genuine cause of hesitation to link lending rates to external benchmark.
The RBI’s deposit data of March 2018 will further substantiate the fear. Out of total deposits – the major part of bank’s resources – 58.9% of deposits of PSBs and 55.6% of private banks are in term deposits that are not impacted by revised lower-term deposit rates to be implemented now. Only incremental rise in term deposits and those falling due for renewal will be at new term lower interest rates. The rest of the deposits are in savings and current deposits. Such large corpus of term deposits at old interest rates for a fixed term continues to keep interest payment obligations intact while earnings on loans will decline. It is a cause of concern for banks.
No commercial entity can sustain unless their earning margins are protected, at least in long term, if not in near term. Pushing commercial banks to adopt non-viable business model may ultimately turn out to be counterproductive challenging financial stability. Apprehending such adversity, many banks have voiced concern on the RBI direction. Moreover, in the slowing state of the economy, the diminishing interest rate cycle may prolong, and profitability of banks already plagued with toxic loans may get further hurt.
Notwithstanding these near-term challenges, it is time for banks to prepare for a floating rate regime. The asset composition of banks continues to be loan centric. It is now increasingly getting loaded with retail, small and medium loans to earn better risk-adjusted returns. The beneficiaries under this segment have relatively less negotiating capacity compared to the corporate sector on pricing of loans. Moreover, after lending automation and linking the pricing to credit rating, the terms of loans are now template-based, with less scope for negotiation, and using discretion. Hence, with the present business model, banks cannot depend more on yield on loans to protect their profitability. They need to diversify, and explore alternate sources of income. The share of fee income is low in PSBs when compared to their private peers. It is one area to tap into to compensate against thinning margins in loan portfolio.
Having built huge digital infrastructure and taking benefit of increased appetite of customers to use electronic banking, it is time for banks to deepen customer connect, and work out specific strategies to reduce intermediation cost to compensate for loss of interest earnings.
The way forward
The combined efforts to augment fee income, improve asset quality, and reduce transaction cost in the medium-to-long term will provide enough resilience to banks to operate more efficiently in the floating interest rate regime linked to external benchmark. The challenges associated with floating interest rate policy have to be tackled by exploring alternate sources of business, and increasing market share with the help of excellence in customer service.
Notwithstanding the near-term constraints of depletion in interest earnings on loans, banks should also consider the long-term opportunities of diversifying business and being able to manage with lower spreads in line with global best practices. Efforts should be made to explore a host of interdependent, inclusive strategies to ensure seamless transmission of policy rates. In the long run, the economy can use the support of strong financial intermediation, with adequate flow of funds to the commercial sector at fair, risk-based pricing and built-in reward for prompt borrowers, and the spread of a culture of loan repayment on time.
The present move of the RBI – considered as an adversity and challenge in the near term – can be converted into an opportunity to rejig the business model of banks, aiming for a greater share of fee income, and a robust market share to build resilience.