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RBI cuts but Banks don’t !!

Feb 17, 2017(11:27)
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The meeting of the Monetary Policy Committee (MPC) of Reserve Bank of India on 7th and 8th February 2017 may have caught most analysts’ off-guard. Most surveys of economists ahead of the monetary policy announcement showed that an overwhelming number expected the central bank to lower policy rate. Since January 2015, the Reserve Bank of India has cut the repo rate from 8% to 6.25%, i.e. by 175 basis points (1.75%). Repo rate is the rate at which the RBI lends to banks. A lower repo reduces the banks’ borrowing costs and vice versa. So, ceteris paribus or other conditions remaining same, every repo rate cut should result in a matching drop in banks’ consumer lending rates, but this has not been the reality in the Indian banking context. Bank lending rates have lagged RBI by a significant margin against a 1.75 percentage point fall in the repo rate in the last 24 months. The average bank lending rate has come down by 0.85-0.95 percentage points.

In the recent monetary policy review meeting, RBI Governor Urjit Patel said that the full effect of monetary transmission has not taken place, leaving enough room for banks to cut rates despite an unchanged repo rate. However on the flip side, banks argue that the repo window is not their sole funding source. They also raise funds by collecting customer deposits — current accounts, savings and fixed deposits (FDs) that range from a few months to several years. Besides, they borrow from banks and institutions, issue bonds and debentures and also use the RBI marginal standing facility window, among others. Therefore, the argument goes, a cut in the repo rate cannot always result in banking lending reduction by an identical margin. The “base rate,” the floor rate to which all lending rates are linked is mainly determined by the deposit cost. A high fixed deposit rate would mean banks are incurring a greater cost of funds with it. Unlike many matured economies, Indian banks donot offer “floating” deposit rates. This has resulted in a situation where lending rates like home loans “float” (meaning, rates goes down when the general interest rates falls), while deposit rates are ‘’fixed’’ (meaning the cost of the funds are static during the entire term). To ensure quicker monetary policy transmission, the RBI has mandated banks to follow a “marginal cost of lending rate” (MCLR) approach, which means base rate be computed on the basis of the marginal cost of funds rather than the average cost. A marginal or incremental cost approach is aimed at faster “transmission” of monetary policy, implying banks will be quick to pass on the benefits to customers every time the RBI cuts the repo rate.

In recent weeks most banks have cut the MCLR, a move often seen as a sign of falling lending rates. Banks are flushed with funds given the surge in deposits caused by demonetization reducing the need to borrowing through high-cost FDs. In the RBI assessment, this will lead to a fall in bank interest rates and revive household spending and corporate investment, regardless of the status quo on repo. “Demonetization-induced ease in bank funding conditions has led to a sharp improvement in transmission of past policy rate reductions into marginal cost-based lending rates (MCLRs), and in turn, to lending rates for healthy borrowers, which should spur a pick-up in both consumption and investment demand,” the RBI said in its monetary policy statement. The amount of bad loans had also come in the way for stickier interest rates. Banks are awash with funds but corporate arenot taking any. Plants have large spare capacity and companies have a stockpile of unsold goods. The scrutiny over bad loans and tighter norms may have slowed down bank credit growth, with banks willing to hold onto piles of cash, rather than cut rates and lend it risky borrowers.

The central bank, it appears, is acutely aware of this. “The environment for timely transmission of policy rates to banks lending rates will be considerably improved if the banking sector nonperforming assets (NPAs) are resolved more quickly and efficiently and recapitalization of the banking sector is hastened,” the RBI said. Lastly, returns earned on a range of popular government-administered small savings schemes such as Public Provident Fund (PPF) and post-office deposits are also major determinants of which way bank lending rates will swing. Since last year, India has shifted to a moving interest rate regime for such deposits, implying interest earned on these schemes are linked to market rates that are revised every quarter. The new system, effective from April 1 last year, has resulted in lower interest rates earned on these schemes given that market rates move in tandem with government bond rates that are currently on a downward trend. Banks say they are forced to offer high FD rates to maintain its attractiveness as a savings avenue ahead of PPF and post-office deposit plans. At present, bank FD rates are hovering between 7-8.5% for different maturity periods. A PPF deposit, on the other hand, offers an annual return of 8% plus tax breaks. It appears, from a purely “returns” point of view for a customer, it is more attractive to invest in a PPF account than bank FDs. The RBI said as much on Wednesday, hinting how high small savings rates were blocking bank interest rate cuts.

Overall on the broader perspective, it is clear from the above mentioned data facts, banking sector may delay the cut in the lending rates till their cost of funds goes down, which can happen once  the returns from the government saving schemes like PPF doesnot get rationalize with the interest rates offered on deposits by the banks. Just like how banks have cut the rate in the lag effect, we expect as the time pass by and high rate FD get matured and renewed at new rates, the lending rate would slip further going forward. Although, RBI doesnot have enough room to cut the rate in the short to medium term, Banks can easily cut 50-75 basis points further.

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