Why the wait for a suitable benchmark to price loans could get longer

The hunt to find a suitable benchmark to price loans continues to be elusive, and the wait could get longer

A quarter of a century after the Reserve Bank of India (RBI) ushered in the prime lending rate (PLR) concept on October 6, 1994, just how banks price their loans continues to be up for debate. The latest is on linking the lending rate to an external benchmark, but just a little over four months after the central bank flagged it off with reference to welding it to retail loans, it has been forced to back-pedal on the same.

Back in December last year, senior bankers had in private expressed their misgivings: “It is good in theory. The rate at which I lend is the function of not just the cost of funds, but the default rate and the appetite for risk, not to mention the substantial provisioning for bad loans for which banks have to set aside capital.” The other aspect is the extent of pre-emptions by way of the cash reserve ratio (CRR) at four per cent and the statutory liquidity ratio (SLR) at 19 per cent — of every Rs 100 raised by way of deposits, Rs 23 is impounded straight away; banks earn no interest on the CRR; and it’s less than the commercial on the SLR. “We have to jump through many hoops before we earn,” says a banker who adds: “In no other country are such vast amounts impounded.”

Few will go on record, but bankers are a divided lot as to what this external benchmark rate should be; many believe it should be left to banks to decide how they price their loans. The fear is we may be headed towards a situation wherein lending rates are by default, administered. According to Arindam Som, analyst at India Ratings, the monetary policy framework is premised on a two-way communication — policy guidance from the central bank acts as a signalling mechanism to the real economy and financial market; in turn, it also gets feedback from the system, which is an input for the monetary policy authority. “Thus, linking commercial rates with the monetary policy rate eliminates the feedback mechanism and transforms the bank deposit and lending rates into a central bank administered rate,” he says.

In its April monetary policy review, Mint Road admitted as much to these concerns when it said on the deferment: “Taking into account the feedback received during discussions held with stakeholders on issues such as management of interest rate risk by banks from fixed interest-rate linked liabilities against floating interest rate linked assets and the related difficulties.” The larger point which comes through is merely looking at systemic measures and expecting banks to price loans accordingly simply does not work.

“The benchmarking of lending rates on smaller loans to external benchmarks was expected to improve transparency in lending rates for the borrowers, even though it would have created challenges for banks given the liabilities for Indian banks are largely fixed rate in nature. In our view, increased depositor education to improve their acceptability of floating rate deposits needs to done first before moving on to external benchmarking of loans and mitigate the interest rate risks for the banks,” notes Anil Gupta, sector head financial sector ratings at ICRA.

No common thread

A closer look at how banks reacted to policy rate actions throws up just one discernible trend — hikes are passed on double-quick. In response to a hike in the repos rate by 50 basis points (bps) — 25 bps each in June and August 2018 — the weighted average lending rate (WALR) on fresh rupee loans went up by 53 bps (since June 2018), but the extent of this rise in lending rates on outstanding loans was muted at 13 bps. After a cut in the repos rate by 25 bps on February 7 this year, the WALR on fresh loans fell by 12 bps despite their being no cut in deposit rates and the marginal cost lending rate of banks (one-year median). 

State-run and private banks are not on the same plane. The former reduced their WALR on outstanding rupee loans during the tightening phase of monetary policy (June 2018-January 2019) due to their inability to pass on the increase in the cost of funds to lending rates; and the spread between the WALR and the weighted average domestic term deposit rates (WADTR) fell. In contrast, private banks were able to maintain a higher spread (WALR over WATDR); reflective of their better pricing power even though the rise in term deposit interest rates offered by them was higher.

Yet another factor is that banks deposit franchise is weakening due to disintermediation by savings plans on offer from mutual funds and insurers. “These channels are gaining share by leveraging their expansion into non-urban markets and offering tax-efficient returns. It has weakened lenders’ term-deposit businesses and as a result they are turning to non-deposit funding sources, such as bonds, which comprised 30 per cent of their new funding in FY18, up from just 11 per cent in FY17,”  says Ashish Agarwal of CLSA in a note. Matters are further compounded when credit outstrips deposit growth. 

Non-food credit growth (y-o-y) accelerated to 15.2 per cent in November 2018, its highest level in the last five years. And although quarterly growth in the same moderated in Q3 of 2018-19 vis-a-vis September 2018 quarter, it recovered in Q4 with YoY growth being higher at 14.4 per cent (up to March 15, 2019) than 11 per cent a year ago. Says R K Gurumurthy, Head-Treasury at Lakshmi Vilas Bank: “Implementation of anchoring retail loans to external benchmarks has been postponed, presumably because rate transmission is slow with credit growth outstripping deposit growth in Q4. We can expect measures that attempt to operationalise external benchmarking of loans alongside floating rate deposits."

The difference in how state-run and private banks reacted to policy rates holds a clue to the battle ahead – just what should be the external benchmark; there could be a huge difference in approach as to how classes of banks view it. 

Mint Road is yet to take up the issue of external benchmarks with the industry lobby group Indian Banks’ Association (IBA), but a senior functionary off-record says, “Our concern is the rate should not fluctuate fast as it will have a major impact on borrowers, especially on the EMIs (equated monthly instalments) on the retail side.” In the case of the repo rate, it remains steady, but on reset moves up and down by 25 bps which is a pretty high change. 

“So, anything which moves gradually by five or 10 basis points is agreeable. What we think is appropriate is a sort of average benchmark, says a twelve-week average yield on the 91-day treasury bill which will smoothen out the kinks (meaning extreme movements on either side),” the aforementioned IBA official adds. The four external benchmarks proposed by RBI were: the repo rate; the 91-day T-bill or the 182-day T-bill; and other benchmark market interest rate produced by the Financial Benchmarks India Pvt Ltd (FBIL). Incidentally in the way FBIL’s stakeholding is imagined, it will turn out to be another club of bankers; its back to the 1990s when bankers met within the portals of the IBA to decide on their PLRs!

As usual what goes unnoticed is the grunt-work that’s needed at the back-end. Senior bankers say the IT systems will have to re-configured, tested, external linkages established with data providers to feed data on benchmark. “While this is doable, it can’t be done at short notice say one week. A month or two is necessary for a smooth transition,”  points out an official at a state-run bank. Recall that banks have to yet recalibrate the operating systems on their automated teller machines despite Mint Road have given banks a head’s up of over a year now!

The more things change, the more they remain the same.