A lot has been said and written about the Friday announcements by finance minister
Nirmala Sitharaman, so I am sticking to one area which is less analysed: the finance minister saying that banks have promised her to link their rates to external benchmarks like repo rate or T-bills. What I am setting out to argue is that the Reserve Bank of India and banks have tried to ensure linking bank rates to repo for the past two decades and neither side has cracked it. Here’s why.
First, depositors in India have clearly indicated their preference for fixed rates over floating. Most depositors wouldn’t know the meaning of repo or T-bills. Even State Bank of India has linked only savings deposits over 1 lakh rupees to the repo. If the savings rate for every depositor were to fall to 2 percent we would have a revolution on our hands. Now current and savings deposits rates can’t be moved much. What about the balance 60 percent of the liabilities? Can they float? Some years ago banks offered a fixed deposit product which offered a higher rate, but carried the condition that rates would be dropped or raised if repo rates changed; the product found no takers.
Savers who don’t mind volatility in their returns can always buy liquid or other fixed-income mutual funds. It is a telling comment that although fixed income mutual funds have existed in India for 25 years, the amount of retail savings going to these products is Rs 7 lakh crore, while bank deposits, representing savers who want fixed returns have Rs 130 lakh crore today. So let us work with this axiom: Indian savers have not got used to floating returns. Hence my second point, if liabilities have fixed elements how can assets alone be based on floating rates. It will expose banks to huge risks, say, if benchmark rates were to fall by 200 basis points by year-end and they have to drop lending rates, but not deposit rates.
Third, even on the assets side (i.e. loans side) banks in India face resistance to floating rates. Can the retail borrower face a 200 basis point hike in one year? Such a shooting up of EMIs will lead to cascading bad loans. While banks are quicker to pass on hikes, even here, the rate of transmission is moderated, so as not to create bad loan risks.
Fourth, Indian banks have products like cash-credit where banks are exposed to the uncertainty of how much will be drawn, making any precise returns calculation difficult. Efforts to wean away corporate borrowers, big and small, from this product has met with resistance.
Fifth, world over, banks have fixed-rate savings products but they normally lend via bonds so the rates float. Also, there are large swap markets which allow hedging fixed products. Such markets don’t exist in India and there are several reasons for this. Creating a large swap market requires real economy participants. RBI's effort to persuade oil companies and other large PSUs who have commodity and interest rate risk to hedge their risk has met with stiff resistance, on fears of being questioned by the Central Vigilance Commission (CVC) or a Comptroller and Auditor General (CAG) who may compare the hedge rate with the spot rate on the date of maturity and pull up the treasury head for causing loss, or even swindling.
The swap markets, as of now, are dominated by a handful of foreign and private banks. PSU banks don’t participate because risk management is a sophisticated skill and their rules don’t permit them to hire such risk managers who command a high price. Any homegrown PSU talent is immediately poached by private or foreign banks. Short point, in the absence of any good market or talent to hedge, forcing banks to float their entire loan book linking it to some external market benchmark may end badly.
Sixth, public and private sector banks are in a way different creatures in India, Even with 30 percent gross NPAs public sector banks get deposits hand over fist. Private banks, even with 3 percent gross NPA have to work hard for deposits. For instance, currently ICICI Bank and Axis Bank are able to get one-year funds via CDs (certificates of deposits) at 6.65 percent, but they still offer over 7 percent for one-year fixed deposits. This is because these banks are looking for stable flows which retail depositors bring. Thus forcing these two very different kinds of banks to one ham-handed regime of external benchmarks is unlikely to work.
Finally, what really do we want? We want transmission. We have got it! If repo rate has fallen 110 basis points in 2019, government bond rates have fallen nearly as much, three-month CD and CP (commercial paper) rates have fallen 160 basis points in the six months since February, while one-year CPs and CDs have fallen 100 basis points. Yes MCLR (banks’ marginal cost lending rates) have fallen only 30-40 basis points, but with abundant liquidity and poor demand for loans, that too will fall.
In our anxiety to be theoretically perfect (via external benchmarking) let us not complicate reality. RBI governor Shaktikanta Das inherited the external benchmarks demand, but having heard out the bankers he wisely back-paddled on it. Two decades of governors, after having moved from PLR (prime lending rate) to BPLR (benchmark PLR) to base rate to MCLR have desisted from full-throttle external benchmarks. North block better leave this to Mint Street and refrain from any “orders” to PSU banks.At best finance ministry must resort to good old moral suasion.