Linking lending rates to external benchmarks

Instead of moving the whole banking system to a new lending regime, a practical way forward would be to let the banks continue with the existing system, duly addressing its weaknesses, if any

The recent proposal by the Reserve Bank of India (RBI) to link all new floating rates, retail (housing, auto etc.) and micro and small enterprise to market determined benchmarks from April 1, 2019, is a paradigm shift for Indian banks. While the RBI believes the new regime will ensure transparency, standardisation, and ease of understanding of loan products by borrowers, the majority in the banking community can foresee a plethora of challenges going forward.

To be fair to the RBI, the external benchmark is popular in Western countries for setting lending rates because banks there depend largely on short-term funds. This makes their cost of funds flexible. In particular, the financial system operates primarily in a liquidity shortage mode and banks take frequent recourse to central bank liquidity. Indian banks, on the other hand, have a strong sticky retail deposit base and hence do not resort to borrowings from the central bank.

Illustration by Binay Sinha

The large share of public deposits in total liabilities for countries like India has important implications for macro stability and policy transmission. First, with banks funding themselves through retail deposits, the source of vulnerability to external contagion is significantly reduced. Second, only 1 per cent of the bank borrowings is currently at the policy rate of 6.5 per cent. Third, the share of public deposits has a preponderance of CASA (41 per cent approximately) that is mostly interest rate agnostic in India with an average interest rate of around 3.5 per cent. The rest are time deposits with a fixed interest rate for the duration of the deposit tenure. Thus when, say, the repo rate say changes by 25 basis points, even under full transmission, there could be at most a 15-basis point impact on deposit rates (25 bpX59 per cent interest sensitive time deposits) and thereby on lending rates. 

Compared to India, demand deposits in developed economies (the UK, the US, Singapore, euro zone countries) do not pay any interest rate and the deposits can be withdrawn at any point of time without any penalty. This minimises the cost of deposits significantly.  Second, even in the time deposit category, the deposits are mostly floating and are linked to a bank’s external benchmark. 

It would be difficult to implement floating retail deposit rates in India. We can’t overlook the fact that even today only about 3 per cent of the population has access to social security, while a large proportion of senior citizens still rely purely on bank deposits as a source of their retirement corpus. Once deposits are linked to market determined benchmarks, the risk of deposit flight from banks to small savings will be quite real. It would be pertinent to add here that floating rate deposits, which were introduced in 2001 and even in 2010 with rates linked to yields on government securities, received a thumbs down from customers. In contrast, senior citizens in almost all developed countries are entitled to generous social security corpus and need not rely on bank deposits for their needs.

Also the RBI issued inflation-indexed linked bonds for the first time in 2013. However, the market is still not developed for the same. One of the reasons for low popularity of this instrument in India is perhaps that Indians prefer stable returns to variable returns as they are linked to the inflation rate.

Alternatively, banks may think on the lines of converting their fixed-rate deposits into flexible-rate deposits by going for interest rate swaps (IRS), where fixed obligations of banks can be converted into floating ones. But, there is a catch here: While globally, the market for IRS is quite huge, in India it is at a nascent stage and suitable counter parties to account for Rs 118 trillion of bank deposits is simply not possible. This will deter banks from venturing into this market, and quite naturally so. 

There are other problems too. In the new regime, computation of the spread will be a huge challenge for banks. The operating cost, currently built in the MCLR (marginal cost of funds based lending rate), will need to be an invariable part of the spread going forward. This will quite naturally push up the spreads, ultimately leading to further discontent in the borrowing community and thereby defeating one of the main reasons behind the introduction of the new regime. Also, given the high degree of competition among banks, freedom to charge the spread will be limited. This will put additional pressure on banks’ balance sheets which are already under severe stress. The banking sector’s net interest margin (NIM), already at a very low level, will go further down. For the record, Indian banks currently have one of the lowest NIMs, at 2.8 per cent (world average: 5.7 per cent).

In the new regime, quarterly or more frequent interest resets would also lead to frequent changes in EMIs, leading to confusion among a majority of the borrowers. Further, as loans are repriced faster than deposits in a downward interest rate scenario, there will be an adverse impact on the profitability of banks while in an upward interest rate scenario, the interest servicing capacity of the borrower will be impacted. Reset frequency is commonly tenor-based in the international markets.

There are costs involved in terms of customisation of technology, documentation-related issues in amending the original terms of the loan contract, executive time and bandwidth of the management required to operationalise the changes. 

Given this, it would be more prudent to let the banks decide the future course of action for themselves. Instead of moving the whole banking system to a completely new lending regime which is alien to the Indian market, a practical way forward could be to let the banks continue with the existing MCLR system, duly addressing its weaknesses, if any. 

The author is DMD & CFO, State Bank of India. Views are personal