The big rate puzzle

Banks seem hesitant to cut interest rates on loans, which doesn't make too much sense

I get the point that some analysts are making: that despite the recent cuts in the Reserve Bank of India's (RBI's) policy rate, bank lending rates are unlikely to come down. But I am not entirely convinced. Yes, some heavyweight banks have raised deposit rates recently and, if they are indeed interested in protecting their interest margins, it would be irrational for them to drop lending rates, even if repo rates are lower. That seems like a fair argument, but the very decision to raise deposit rates seems a little inconsistent with some facts on the ground.

I do not claim to have a solid counter-argument. All I am saying is that the markets for deposits and loans present some curious conundrums that need to be solved before one can arrive at a view on the direction of interest rates. Let me offer a quick apology at this stage. Since I am in the banking industry, it might not be fair on my part to identify specific banks - thus, readers will have to tolerate the lack of these specifics throughout this column.

 

Let me start with the liquidity situation. The overall liquidity adjustment facility (LAF) deficit - the amount that banks borrow from the RBI at the repo rate - is undeniably high. However, from what I hear from my peers in the industry, just a couple of banks account for a significant fraction of the borrowing. If you exclude them, the liquidity deficit seems far less ominous.

In fact, a number of large banks seem to be sitting on surpluses that they are lending in the call market or investing in government securities. Some of them have incidentally publicly acknowledged that they do have substantial liquidity on their books. Actual government bond holdings of banks (at about 30 per cent of their liabilities) are much higher than the amount mandated by the statutory liquidity ratio (SLR) of 23 per cent. This represents a pool of liquidity that banks can draw upon to fund credit demand. If this is the case, then the decision to raise more lendable resources by offering higher deposit rates seems a tad difficult to explain.

There are perhaps three ways in which to justify higher deposit rates. First, the deposit-rate-raising banks anticipate a pickup in credit demand and, despite their current surpluses, want to make sure that they have enough money to lend when the surge does happen. They would then also be able to make up for the rise in deposit rates by charging higher rates on loans. I would find it difficult to find a rationale for this. Economic indicators, both official and anecdotal, point to slowing, rather than accelerating, economic activity. In fact there seems to have been a marked dip in the economic cycle from the third quarter of 2012-13 (GDP growth, if you remember, was an abysmal 4.5 per cent in this quarter). A number of studies show that the credit demand cycle lags real economic activity by about eight to 12 months. If banks buy that correlation, credit demand is likely to start falling, rather than rise, in the months to come. This logically means that banks should prepare to drop, rather than increase, lending rates.

Some of my colleagues in the industry suggest that banks are offering higher deposits to meet deposit growth targets. Aggregate deposit growth for the banking system as a whole (now at about 13 per cent) has fallen way short of projections at the beginning of the year and, since the aggregate is a sum of its parts, individual banks' deposit growth rates have also lagged behind targets. This is possible. However, for banks, this strategy of targeting liabilities independent of the asset side of the balance sheet can hardly be viable in the longer run. I would argue that in the new fiscal year banks will be forced to do a serious rethink about the kind of deposit growth they want to target, given the likely glut in the credit market.

The third explanation for the apparently puzzling deposit rate policy is the following. Banks that raised rates recently had fallen behind their peers in terms of pricing in the deposit market. In hiking their rates, they were just catching up with the others to ensure that they did not lose much market share. If their competitors start to lower deposit rates, they are likely to follow.

Here is my prognosis. Loan demand is likely to fall going forward as the effects of a slowing economy catch up. Few companies seem interested in putting on fresh capacity, and projects that commenced earlier are coming to closure. As the demand for funds from ongoing projects comes to an end, there could be a sharp drop in the demand for investment-related credit. Going by private surveys, consumer demand has been slowing, which is bound to take a toll on retail credit demand. A big driver of retail loans is car and truck financing, and the bottom seems to be falling out of that market. As the seasonal (slack season) improvement in liquidity kicks in in the first half of the fiscal year, banks are likely to switch strategy from chasing deposits to chasing loans. This would mean cutting lending rates by a significant amount in some cases and drawing on extant surpluses - including the money parked in government bonds - to fund credit rather than raising deposits at higher costs

Slowing demand for loans would mean that these surpluses are unlikely to dry up. In fact, if credit demands falls sharply, banks will find themselves sitting on larger surpluses even if deposit growth rates do not budge an inch. Thus, banks will have to do a serious review of their deposit strategy if the yields on their assets decline. It seems logical to me to expect cuts in deposit rates to follow. This would be the inevitable consequence of the interplay of market forces. Whether the RBI chooses to cut its policy rates or stay on hold will make a difference only at the margin.

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The writer is with HDFC Bank. These views are personal