In defence of banks’ lending rates

In a bank-dominated system like India, the transmission to banks’ lending rates is the key to the successful implementation of RBI’s monetary policy. Often, banks are blamed for slow and incomplete transmission of policy rates and limited interest reduction on existing loans.

Banks’ lending rates primarily depend on the Marginal Cost-based Lending Rate (MCLR). MCLR is revised every month based on the Marginal Cost of Funds, Negative Carry on Cash Reserve Ratio, Operating Cost and Tenor Premium/Discount. Banks have to factor in the level of bad assets while pricing their assets. The marginal cost of funds is the main component of MCLR.

The bank credit (excluding interbank advances) of scheduled commercial banks (SCB) has improved to Rs 97 lakh crore as on July 19 (a 12.2% growth year on year) and deposits (other than from banks) to Rs 126 lakh crore (10.6% growth). When the credit grows faster than deposits, banks have to focus on mobilization of deposits/resources.

Bank Deposit Rates

Both Current Accounts (nil interest) and Savings Deposits (3.5%+ interest) are insensitive to price and there are limits to mobilisation. Term deposits are, to a great extent, price sensitive. Term deposits are on fixed rates and re-pricing happens only on maturity/fresh deposits. The maturity profile of deposits of SCBs (2018) indicates that around 55% are maturing over the one year period (24% in 1-3 years, 10% in 3-5 years and 21% in over 5 years), indicating time lag in repricing existing deposits.

The main benefits of bank deposits are “risk-free” assured return, liquidity from premature closure/partial withdrawal or loan against the deposits, convenience and reach. Small Savings schemes now offer higher risk-free/assured returns – some of them with tax benefits. While interest rates on Small Savings are expected to be benchmarked on market rates, it seldom happens.

For July-September, the Small Savings rates are marginally reduced by 0.10% -- still more than the rates offered by banks (for instance, 5-year NSC - 7.9%, PPF -7.9%, Senior Citizen Savings Scheme – 8.6% and Savings Deposit, unchanged at 4%). Mutual Funds are another avenue for household savings, though returns are associated with risk.

Taxpayers generally do not prefer bank deposits as bank interest is taxable. They have other avenues to defer/avoid tax and get better tax-adjusted returns. Consequently, banks are reluctant to sharply reduce deposit rates and bring down MCLR for fear of losing deposit customers.

It is true that the average interest on term deposits is coming down. The weighted average domestic term deposits interest of SCBs was 8.91% in September 2013, fell to 6.5% in November 2017 and then started moving in both directions. As of June, it is 6.84%. Reduction in repo rates widens the gap between term deposit interest and repo rates. The term deposits interest was higher by 0.26% in August 2018 and has since risen to 1.44% now with the reduction of repo rate to 5.40%. So, it is unfair to expect a perfect correlation between repo rate movement and MCLR.

Existing Loans

Under the MCLR system, banks charge spread/margin/mark-up over the MCLR for two elements -- business strategy and credit risk. Variations are observed in spreads from month to month, from bank to bank and from sector to sector. Some banks offset the reduction in MCLR by jacking up spreads and offer certain products only on fixed rates.

Under floating rate term loans, the effective rates to the borrowers are one-year MCLR+spread and the rates are reset on annual basis by keeping the spread unchanged. When MCLR falls, effective rates come down. Generally, considering operational conveniences, the EMIs are not changed; but the loan tenure gets reduced. So, existing term loan borrowers (Housing, Auto, Personal Loans, etc.) invariably get the benefit of rate reduction. Sometimes, on account of higher spread charged earlier, there may be marginal difference between interest on existing loans and fresh loans. The allegation that banks are not passing on the benefit of rate reduction to existing borrowers is not correct. Further, on August 2, the RBI reiterated that “banks shall not charge foreclosure charges/prepayment penalties on any floating rate term loan sanctioned, for purposes other than business, to individual borrowers with or without co-obligant(s)”. In a falling interest rate scenario, individual customers should prefer floating rate interest loans.

In case of fixed rate loans, the rate modifications on existing loans happens as per the reset slab/period stipulated for changing the effective rates.

From January to May, the difference between the weighted average lending rates of SCBs in fresh rupee loans and outstanding loans was between 0.41% to 0.66%. However, in June, it went up to 0.75% (existing loans --10.43% and fresh loans – 9.68%). The difference may be on account of large proportion of fixed rate loans, time lag in resetting floating rate loans and variations in spread levied on MCLR.

Both MCLR and repo rates move in the same direction, but they cannot do so in the same proportion. Banks do pass on rate reduction to both existing and fresh borrowers, but not to the same extent as the RBI cuts repo rates.

(The writer teaches banking at ICICI Manipal Academy, Bengaluru)