SBI’s smart cut: What does it mean for reform?

State Bank of India (SBI) scored a sixer on Friday when it announced linking its interest rates on saving deposits and short-term loans to the Reserve Bank of India's (RBI) repo rate.

The bank said it will link its savings deposits of over Rs 1 lakh to the repo rate and fix it at 275 basis points below repo rate ( i.e. at 3.5 percent) as of today. Simultaneously, on the loans side, it will link all cash credit limits and working capital to the repo rate, fixing them at 225 basis points above repo. One basis point of one-hundredth of a percentage point.

The arrangement comes into effect from May 1.

As of now, deposits above Rs 1 lakh constitute about 32 percent of SBI’s total deposits while its cash credit and allied loans account for about 25 percent of the loan book. Now loans are typically about 70 percent of total deposits. So straightaway, a larger amount of SBI deposits get cheaper while a slightly smaller amount of loans will yield less interest, if and when the RBI cuts rates. So SBI would have transmitted rates and yet come out a winner.

On the liability side, large private lenders may not have too much by way of over Rs 1 lakh deposits, but on the loan side, they are about 50 percent into retail loans. Cash credit and working capital may form less than 25 percent of their book. Faced with competition from SBI, they may be in a position to lower lending rates SBI-style and also drop their savings deposit rate for large accounts. But the problem may well be for smaller PSU banks, who have lower savings deposits and higher exposure to cash credit. These may see an erosion in margins.

It appears to be a nudge from the government and maybe even the RBI to ensure the rate cut gets transmitted. It is a bit strange that SBI chose savings deposits since they are, by nature, interest rate insensitive. Logic will require that term deposits should be linked. But most bankers say floating rate deposits aren’t clicking with depositors. Those who are rate-savvy anyway prefer fixed income funds.

Chances are that the SBI's move will be followed by large private banks, since, as was just explained, they won’t be hurt if they followed suit. This will succeed in rate transmission at least after the April cut, in time for the election season. Actually, it may be slightly negative for public opinion since the rate cut may not be available for retail loans.

But more importantly, what happens after the first rate cut? It is possible that savers with over Rs 1 lakh in their deposits react by sweeping their excess over one lakh into term deposits. And then banks may have to improvise on the loan side to keep their margins intact.

Separately, any accident in the fixed income fund market can bring more money into bank deposits and any lowering of interest may be overlooked by depositors. (This looks a little unlikely now since banks are actually complaining that they are starved of deposits and don’t want to cut rates).

A more important scenario that we must watch out for is what happens when the interest rate cycle turns. SBI and other banks will have to raise rates immediately for both depositors and for their cash credit clients. This time it won’t work in their favour, so chances are they will have to find some adaptations.

A point that we may be forgetting in this entire transmission argument is that the transmission ought to happen through the bond market. At the moment, rate cuts are not getting transmitted because the government is borrowing more than the usual and that’s keeping yields high. If there were no open market purchases of bonds  (OMOs) by the RBI, yields would be even higher. We may, therefore, see a situation where companies that can otherwise borrow in the markets run to the banks. So a move intended to transmit the rate cycle may end up stultifying bond markets. In the long run, that’s not reform, it is retrogression.

So the move may be a sixer for SBI now, but for the economic reform and greater marketisation, it is a tame draw.