Linking loans to repo not good for banks, borrowers

The Reserve Bank of India’s (RBI) new rule to link all floating personal and retail loans to its repo rate is like squeezing banks when the economy is slow and squeezing borrowers when it picks up pace.

Initially, the equated monthly instalments (EMIs) will come down, albeit marginally, as long as the central bank keeps cutting the repo rate. Ultimately, when the lower rate regime fades and the interest rates start moving up, all the home or auto loan seekers will have to cough up more on their EMIs every three months. The central bank’s new norm to be effective from October 1, requires the banks to revise the EMIs on loans every quarter.

Moreover, do not get upset if the loans do not become cheap in tandem with the repo cut or reduction in any of the other three external benchmarks to which the loans would be linked. The game is not as simple as it appears. No bank, already saddled with bad loans, would like to take a hit on its margins and the RBI has ensured that it does not. How?

This is by giving ample freedom to lenders to decide the spread over the external benchmark. (Bank spread is the difference between the interest rate a bank charges to its borrowers and that it pays to a depositor). So, if a home loan is linked to repo and the RBI cuts by 100 basis points, it will not mean that the home loan would be slashed by 100 bps too.

According to the flexible spread that the central bank has allowed the lenders to fix over the repo, it could be 200 basis points (bps) or more depending on their cost of funds. Currently, the State Bank of India, which became the first lender to link its home loan product to repo, has fixed its lending rate 225 bps above the repo. But to protect their margin, some banks can even raise the spread to 400 bps or 500 bps. In that case, the loans may actually get costlier even in the lower repo rate regime.

Banks’ margins to be hit

The RBI may have taken such a step either under pressure from the government, which almost always keeps nudging the central bank to make loans cheaper or under pressure from the Supreme Court, which had asked it to examine why the benefits of a rate cut were not reaching the borrowers.

But, the move is neither being appreciated by the lenders nor by economists and experts, who say it would lead to a weakening of banks when the economy is plodding. Why?

Because, while the RBI has already linked the loans to floating rates, most of the deposits are still held in fixed rates. Those do not get revised by the changes in the external benchmarks. So, if a bank keeps paying higher rates to its customers on their deposits, it cannot go on slashing lending rates every quarter. And, if it does so, its interest margin will suffer.

Now, this leads to a question on what stops the RBI from applying the same rule for deposits? Not that simple. Banks, especially the newer ones, offer far higher interest rates even on saving deposits to build their base (If a bank does not have a healthy deposit base, it cannot possibly indulge in lending activities).

The moment the banks slash their deposit rates, they lose customers to other small saving instruments or postal savings, which have far higher interest rates. Hence, linking deposits to floating rates may hurt banking business even more. The RBI cannot take such a step until Indian banks have so robust a balance sheet that it does not hurt if they lose a few customers to rival lenders. That is a long way to go.

So, while faster transmission of a rate cut may happen by linking loans to an external benchmark, there is no guarantee that loans will get cheaper for borrowers significantly even now. When the economy accelerates or inflation rises and RBI decides to increase interest rates, there will be a significant rise in EMIs for borrowers. The central bank has tried various routes to improve transmission from bringing in prime lending rate in 1994, the benchmark prime lending rate in 2003 and base rate in 2010 and the marginal cost of lending rate in 2016. None have worked.

Earlier, the banks had very high NPAs due to which their interest margins took a hit and transmission suffered. But now, banks are finding it difficult even to garner deposits as there has been a gradual decline in household savings. The slowing economy has put additional pressure on people’s ability to save and deposit in banks, which is making lenders’ cost of funds expensive and lending difficult.