In an effort to uplift the
falling economic growth rate and consumer sentiment, RBI made an announcement
regarding external benchmark based lending on 4th/Sep/19.
Though the final guidelines are awaited yet, the details can be read in
this circular. However RBI may deny that
this announcement has nothing to do with the current state of the economy, but
the timing of this announcement and its’ direct influence on reviving the
consumer and business sentiment by lowering the cost of borrowing tells the
opposite of it.
I attempt to do a quick
analysis of this announcement in the Good, the Bad and the Ugly style…!
The Good:
1. Better and faster policy
transmission:
Undoubtedly, linking loans to an external benchmark rate seems more effective and faster policy transmission
tool. We have come across as a borrower, the propensity of bank to quickly
raise the lending rates when there is a rate hike cycle but being laggard when
there is rate cut cycle. RBI has been suffering a severe headache due to
this reluctance of banks to reflect a rate changes disproportionately and with
longer lag. This year so far 110 bps (Basis point) rate cut is made in repo rate
by RBI of which very little has been passed on by
banks to the customers. For varied reasons, banks were less willing to pass
on these cuts.
The Bad:
1. Time period mismatch:
The external benchmark rates provided
by RBI are 1. Repo rate of RBI 2. Three-month T-bill yield 3. Six-month T-bill
yield or any other market interest rate as published by Financial Benchmarks
India Private Limited (FBIL). As it can be observed, these benchmark
rates are there for very short time period instruments. The lending rate for
long term business loans to MSEs and home loans to retail borrowers if linked
to one of these external benchmark rates, it may lead to interest rate risk as
well as asset-liability mismatch due to time period mismatch. (When long term
loans are linked to short term rates and not long term rates)
2. Challenges of linking
deposits rates to external benchmark:
To take the pressure off from
volatile profit margin, banks may eventually introduce linking of deposits
(savings account, term deposits etc.) to the external benchmark rate. As per
this article, SBI
being one of the first movers, has announced the linking of savings deposits
to the external benchmark rate. For CASA (current account-savings account)
deposits, floating saving rates may not be much of a deterrent but knowing
Indian depositors for term deposits, they may show strong reluctance in
adoption of floating rate term deposits as they generally crave for
stable/fixed rate of interest on such deposits. Banks with higher CASA portion
in their total deposits may have a less bumpy ride to migrate to external
benchmark linked deposit system but for others (having a higher contribution
from term deposits) they can be placed between the devil(keeping the fixed rate
on deposits & hurting the profit margin) and the deep blue sea. (Moving to
floating deposits rate - facing depositors’ wrath & losing the business) One
remedy to this challenge can be if all banks migrate to floating deposit rate system
it may mitigate the competition of fixed-rate v/s floating rate deposits but
still there will be competition.
3. Not market
–driven rate but RBI governed rate:
It may not be well advised to
link commercial rate directly to the monetary policy rate (repo rate) as both
rates are set and revised based on different factors.RBI manages the repo rate
keeping in mind several factors and repo rate management has multiple
objectives to achieve. A floating interest rate of loan benchmarked against
repo rate may not be a correct reflection of the market forces.
The Ugly:
1. Volatile profit margin of
banks:
The announcement of linking
loans to an external benchmark from 1st/Oct/19 may set the cat among
pigeons (banks). For banks maintaining net interest margin may
turn out to be a walk on a thin line, especially when lending rates (rates on
various loans) are pegged to external benchmark rate which will be reset at
least every 3 months while borrowing rates (rates on various deposits) which
are mostly fixed/constant for the tenure. If a bank chooses to keep borrowing
rates fixed/constant while on other hand lending rates are going to be
flexible/volatile then this may exacerbate the interest rate risk problem and
reduce the predictability of bank’s profit margin. So, an act of boosting the
customer sentiment (by lowering the borrowing cost) may lead to the creation of
hindrance for NPA-stricken and already struggling banking sector.
2. Faster revisions of EMIs or
interest payable:
Mandatory linking of floating
loans to an external benchmark rate and resetting the rate at least once in three
months is going to result into faster revisions of EMI amount or effective
interest payable amount. Changing EMI amount which I hope banks will not resort
to, can lead to gruesome experience for individual and MSEs borrowers. But
borrower’s effective interest payable amount is certainly going to be more
fluctuating in nature. A very fine analysis of pros and cons of this
announcement is done in this article.
3. For long term borrowers -
short term bliss and long term pain:
After a cut of total 110 bps
and expecting a few more rate cuts, we may reach at the end of the rate cycle.
Cost of borrowing will be fairly lower than the prevailing borrowing cost for
various loans from 1st/Oct/19 for new borrowers and this may lure
more and more people to borrow. Fruits of lower borrowing cost will be
sustained for short term may be around for next 18 months (as per my
expectations) after that interest rate cycle may bottom out and if the economy
is reviving the gradual rate hike cycle may commence. Once the hike cycle
starts, the long term borrowers be it individuals or MSEs are going to face
higher interest cost leading to increased interest payout or larger EMIs. In a
nutshell, looking at the interest rate cycle for short term there will be lower
cost but in longer term as reversal in cycle kicks in increased cost will be
inescapable.
I believe (I can be wrong
here) there is a possibility of identifying better external benchmark rate as
the currently announced benchmark rates are either not market-driven (repo
rate) or having a mismatched time period(T-bill yield) with underlying loan
products.
