Credit policy repo hint may lead to rate rise

The Reserve Bank of India's monetary & credit policy for the second half will signal a hardening of interest rates in the banking sector.

This is because money market participants anticipate a 25-50 basis point hike in repo rates in the policy pronouncement.

A hike in the repo rate will set banks raising their respective prime lending rates correspondingly, said G V Nageswara Rao, managing director and CEO, IDBI Bank.

Banks today have not hiked deposit or lending rates even as the government securities market has captured the hardening interest rate movement.

Interest rates on fixed rate home loans have seen a hike of 25 to 50 basis points, but this rise has not percolated to floating rate home loan products.

The liquidity overhang in the system, and the fact that banks' deposit and lending rates are pegged to interest rates on short-term market instruments are the two key reasons for the banking sector not having mirrored the tightening yield curve in the government securities market.

"The market always capture the interest rate first, and therefore even as long-term yields have gone up, our deposits have not been repriced as they are linked to short-term yields," said Nageswara Rao.

Short-term yields are usually linked to repo rates. Similarly working capital loans are linked to short term papers like 364-day treasury bills.

Recent cut-offs on T-bills have been at higher yields and have gone up to 5.4 per cent. However, as banks are cutting down on their average duration of government paper to less than two years, demand for one year paper has pushed down secondary market yield for 364-day T-bill to 4.92 per cent.

"So as lending rates should have gone up since the Reserve Bank of India has been hinting at higher interest rates through higher cut-off yields, the rising demand has resulted in these yields not being sustainable," said a senior private sector bank official.

The government has started paying 50 basis points more and the market expects banks to start thinking of repricing their rates in keeping with higher cut-off in yields, he added.

"If treasury bill rates were to stabilise at current levels or even at higher yields, this will trigger banks to hike rates on floating rate loans," said a senior official at a leading home loan financing bank.

Floating rate loans are related to T-bill yields rather than 10-year benchmark paper. This is because banks fund their lending through one-year and short-term deposits, and hence would look at the cost of one-year money.