Banks must appropriately price in credit risk: Ex-RBI deputy guv Thorat

Usha Thorat says it's absolutely essential for financial stability that bank spreads are not under threat

With the Reserve Bank of India (RBI) deciding to implement linking of retail and micro, small and medium enterprises (MSME) loans with an external benchmark from October 1, banks are expected to be under pressure to deliver. Usha Thorat, former deputy governor of the RBI and chairperson of Financial Benchmark India (FBIL), tells Joydeep Ghosh that it’s absolutely essential for financial stability that bank spreads are not under threat. Edited excerpts:

How do you think the RBI decision will play out for banks?

The decision to direct banks to link retail and MSME loans with an external benchmark is primarily guided by the need for interest rate signals to transmit to the smallest borrower. Large borrowers have sources of funds other than bank borrowings, such as CPs and bonds. In the latter, the interest rate transmission works much faster. In the case of retail and MSME loans, while interest rate hikes are transmitted fairly quickly, reductions take a longer time. External benchmarks are based on the prices of market instruments, which respond to changes in the policy rates quickly. Hence, asking banks to link their retail MSME loan rates to external benchmarks will ensure better transmission of the monetary policy and be in the interest of small borrowers, as there will be greater transparency. 

How will the pricing of loans change?

Banks’ price loans are based largely on the cost of their deposits. CASA constitutes about 40 per cent of their liabilities and are not interest rate sensitive. Fixed deposits constitute 50-70 per cent. The average maturity of these deposits is from one year to 18 months. Hence, for their asset liability management (ALM), banks prefer to link loan rates to their deposit rates on fixed deposits to keep their net interest margin stable. It is, however, observed that the one-year deposit rates of banks are closely correlated to some of the FBIL benchmarks, like 364-day T-Bill rate or 1-year G-Sec yield, or the one-year overnight index swap rate. Hence, banks could link their floating rate loans to an appropriate one-year benchmark to manage ALM. The RBI-specified three-month reset could pose challenges and it may be better to leave the choice of reset to individual banks. 

Some banks may have concentration of liabilities at the five-year segment and, hence, may like to reset their floating rate interests at longer intervals — as, I believe, State Bank of India is asking for. 

In the absence of floating rate deposit rates, will banks be able to effectively execute this?

Depositors in India do not want fixed deposits to be linked to floating rates, even if these were linked to the inflation rate. But banks will need to see how they can incentivise floating rate deposits to have more flexibility in their ALM. There are difficulties but a beginning has to be made. But, as I said, it is possible to use the average period of fixed deposits made by members of the public, such as one year as a way of linking their retail loan rates to the one-year external benchmarks currently available. In case banks do not want to change the lending rates daily, they could use the monthly moving average of these external benchmarks, and use it for setting the rates for loans taken during the month. 

The financial sector is under duress due to non-performing assets and other problems. Do you think this will put more stress on their margins?

I think banks will be able to manage this by appropriately pricing in their credit risk. Apart from the credit risk attributable to individual borrowers — the so-called idiosyncratic risk — the credit risk as a whole is enhanced due to the uncertain macro-economic condition. These aspects can be transparently built into loan pricing by banks. Like, when overall NPAs are going up, there may be a credit spread across borrowers over and above the individual credit spreads. It is essential for financial stability that bank spreads are not under threat, but nor should they be excessive. 

Rates of the National Savings Scheme (NSS) are quite high. It has been argued that without fall in rates, banks will find it difficult to cut deposit rates sharply. How does one solve this conundrum? 

This argument is not new. The liabilities under the NSS is about 10 per cent of the total deposit liabilities of scheduled commercial banks. Currently, the government has tried to correct the distortions between the rates of small savings and bank deposits by linking its various small savings schemes to the G-sec rate. The government could also think of using the FBIL benchmarks for setting interest rates for small savings.