Banks differ with RBI on approach to pricing loans

Till a fortnight ago, banks were reluctant to bring down interest rates despite the 50 basis points (bps) cut in the repo rate since January. This made Reserve Bank of India (RBI) Governor Raghuram Rajan do some straight talking in the April 8 monetary policy review. There was no point in reducing the repo rate further till banks passed on the benefits of earlier cuts to customers, he observed.

"I don't see an environment where credit growth is tepid. Banks are sitting on money so to speak and their cost of funding, their margin cost of funding, has fallen. The notion that it has not fallen is nonsense," he added.

Within hours, the State Bank of India (SBI), the country's largest bank, reduced its base rate by 15 bps to 9.85 per cent. The base rate, or the minimum lending rate, is used to price loans. In response, ICICI Bank, HDFC Bank and Axis Bank also cut their base rates.

Borrowers often wonder why banks do not pass on benefits of repo rate cuts immediately. The RBI, too, would like faster rate transmission. But banks say it's easier said than done.

In order to improve the efficiency of monetary policy transmission, the RBI will encourage banks to move in a time-bound manner to marginal cost of funds-based determination of their base rates. The detailed guidelines would be issued shortly.

Raghuram Rajan

Governor, RBI

At the heart of the issue is the way banks calculate base rates. While they take into account the average cost of all funds raised by them, the RBI wants them to use the marginal cost of funds, that is, the rate they pay for new deposits or borrowings.

Banks say it's the average cost of funds that matters. For instance, they say that their cost of funds has not come down in spite of the recent repo rate cuts. One reason is that depositors are preferring to park money in fixed deposits than keeping it in savings accounts because of fear that interest rates will fall further from here. Deposit growth, too, has been tepid because of high rates on government small savings schemes and is coming in the way of reduction of deposit rates.

There is not much borrowing taking place from the market. The repo borrowing is capped at a certain level. So there is not much arbitrage also.

B. Sriram

MD, SBI

"The marginal cost of funds will have an impact only if deposit rates come down. So, where is the question of transmission of rates?" says B. Sriram, Managing Director, SBI. The biggest source of bank funds today is current and savings accounts on which the interest rate is low. Fixed deposits come next, followed by the RBI's repo window, call money market and commercial papers.

"Deposit growth has slumped to 10-11 per cent, which is reducing our reliance on low-cost funds and putting pressure on margins," says another banker.

Bankers say there is also an asset - liability mismatch. A large part of banks' loans or assets have floating rates whereas deposits or liabilities have a fixed maturity of one or more years. Therefore, replacement of old deposits with lower-cost deposits takes two to three quarters.

Banks use marginal cost of funds when there is sufficient liquidity available at that rate to fund a reasonable proportion of the asset portfolio.

Aditya Puri

MD and CEO, HDFC Bank

Base rates are also influenced by liquidity and credit growth. Sriram of SBI says earlier repo rate reductions had an impact as banks were borrowing heavily from the RBI's repo window and so their cost of funds fell with the repo rate. But today when there is excess or reasonable liquidity, not much borrowing is taking place from the repo window.

Clearly, one of the reasons banks are not borrowing much from the repo window is the slow credit growth of 9.5 per cent. Companies are either not borrowing or are raising money overseas or directly from the domestic market.

Some say risk also plays a part in deciding interest rates. Today, almost two-thirds of the banking sector is grappling with deteriorating asset quality. "They (especially PSU banks) don't want to write more loans by just reducing interest rates. Their risk perception is higher in the current market scenario," says a private sector banker.

A year ago, the RBI's own working group on pricing of credit had talked about the difficulties in shifting to the marginal cost of funds. The 12-member group, headed by former deputy governor Anand Sinha, concluded: "It may not be appropriate to mandate marginal cost at this juncture taking into account the difficulties for majority of banks due to the maturity profile of deposits."

While the RBI and banks are slugging it out, the borrowers are cheering the current rate war in the market.

Benchmark Rates: A Brief History

Oct 1960

For the first time, RBI prescribes a minimum lending rate

March 1968

Maximum lending rate introduced

January 1970

Minimum lending rate re-introduced

January 2003

Benchmark Prime Lending Rate (PLR) introduced

July 2010

A new base rate introduced, replacing the PLR. Banks not allowed to lend below this

September 2013

Banks allowed to review their base rate methodology after fi ve years

January 2015

• While computing the base rate, banks given freedom to calculate cost of funds on the basis of average, marginal or blended cost of funds
• Review period of base rate methodology reduced from five to three years

April 2015

RBI considering asking banks to link their base rate with marginal cost rather than average cost of funds.