<div><em>Banks will find it tough to pass on RBI rate cuts, argues <strong>Raghu Mohan</strong></em></div><div> </div><div>At long last, the Reserve Bank of India (RBI) has obliged with a repo rate cut of 50 basis points (bps) to 6.75 per cent -- a four-and-half-year low. It left the cash reserve ratio or CRR (the proportion of deposits banks’ park with Mint Road) and the statutory liquidity ratio or SLR (the proportion of deposits to be invested in government securities) unchanged at four per cent and 21.5 per cent, respectively.</div><div> </div><div>Will you and I get to borrow cheap from here on? Will India Inc., go the whole hog and invest big time? Unlikely.</div><div> </div><div>Just read this line from RBI governor’s Raghuram Rajan’s policy text: “While the Reserve Bank’s stance will continue to be accommodative, the focus of monetary action for the near term will shift to working with the Government to ensure that impediments to banks passing on the bulk of the cumulative 125 bps points cut in the policy rate are removed”.</div><div> </div><div>The reference to a 125 bps cut is to those in the calendar plus today’s 50 bps. And what exactly are the impediments?</div><div> </div><div><strong>What’s The Context Here…</strong></div><div>That Mint Road has gone in for a deep 50 bps cut in the repo rate – the price at which banks borrow funds from RBI – is a clear indication of the quagmire we are in. Let’s also get this clear: a repo rate cut does not lead to an infusion of funds into the banking system unlike a cut in the CRR or SLR (to the extent that banks have to invest less in government paper). On the latter, you also need to remember that given the times we are in, banks have taken the option to invest more under SLR. The RBI’s Annual Report for 2014-15 says banks continue to hold around 28 per cent by way of SLR despite a slash in it over time to 21.5 per cent (from 23 per cent).</div><div> </div><div>Mint Road’s reasons: “… the buffer providing access to collateralised borrowings from the wholesale funding market and the Reserve Bank. Maintaining excess SLR securities also helped banks to weather the impact of the current slow phase of the economic cycle on their balance sheets and earnings”.</div><div> </div><div>That’s why a 75 bps cut in the repo rate between January and June 2015 saw only 30 bps pass-on to you and I by banks. Lower bond yields mislead. Mint Road captures this reality when it notes that the financial markets have transmitted it’s past policy actions (lower yields on commercial paper and corporate bonds), but banks have done so only to a limited extent (as in lending rates have been stubborn).</div><div> </div><div>On Tuesday, the point was repeated: “The median base lending rates of banks have fallen by only about 30 bps despite extremely easy liquidity conditions. This is a fraction of the 75 bps of the policy rate reduction… even after a passage of eight months since the first rate action by the Reserve Bank. Banks’ deposit rates have, however, been reduced significantly, suggesting that further transmission is possible”, observes RBI.</div><div> </div><div><strong>Will Banks’ Oblige From Here On?</strong></div><div>A month from now, Mint Road will come out with a new base rate (BR) calculation – marginal cost of funds from weighted average cost of funds; RBI intends to implement it from 1 April, 2016.</div><div> </div><div>Dhananjay Sinha, Head-Institutional Research at Emkay Global, is of the view that if implemented in its current form, these norms are likely to be negative for banks' NIMs (net interest margins) until the average cost of funds catches up with the marginal cost of funds. Why so? Bank deposits were contracted at a higher rate (only a relatively small portion of it were contracted at a lower rate after and during the cumulative repo rate cuts of 125 bps in the calendar so far; of which 50 bps happened only today). Therefore, a cut in the BR will only mean banks will have less to pocket for themselves.</div><div> </div><div>A way out, as Sinha says, is for banks to either increase the spread over the BR or let NIMs get impacted. Of course, in a rising rate environment, the proposed BR regime will work in favour of lenders as banks would pass on higher rates immediately. “Hence, we expect movements in BRs, and hence NIMs, could likely be volatile and frequent, which is likely to make banks' balance sheets more vulnerable to sharp interest rate movements””, adds Sinha.</div><div> </div><div>The essence of the above is banks have two options: either let NIMs dip and crib. As Pawan Agrawal, Chief Analytical Officer-CRISIL Ratings noted when RBI came out with its BR draft norms: “Our base-case is that profitability of banks will have a one-time impact of around Rs 20,000 crore in fiscal 2017, which would be equal to 15 per cent of the total estimated profit of the banking system for that year. The actual impact will depend on whether the banks will be given a leeway to make this shift over a longer timeframe in the final guidelines.”</div><div> </div><div>Agrawal says returns of banks that lend mostly on a floating rate basis will be significantly impacted in an environment of falling interest rates – as floating rate is pitched over the BR. As the BR falls (and along with it the floating rate), so will the interest income of banks. And that banks with low levels of current and saving accounts, or relatively longer tenure-term deposits, will also be majorly affected. That’s because their cost of funds will not come down soon enough -- as they will continue to pay interest to depositors at the old rate (before a policy rate cut).</div><div> </div><div>Or banks up the spread over the BR itself (which they are legally allowed to have anyway). If this happens, you will see a peculiar situation. Banks will publicly state they have dropped their BRs – not in proportion to the current repo rate cut, but a cut by a small margin – but when you actually go to borrow, the rate will more or less be at what they were before the current repo rate cut. Lower lending rates will be an illusion – that’s what most likely to happen anyway.</div><div> </div><div>What’s not to be lost sight here is that liquidity has not been issue at all; it sloshes about, but there have no takers for it at the banks’ credit window.</div><div> </div><div>Mint Road’s inter-bank money market numbers are reflective of the deeper rot in the economy. Liquidity conditions eased considerably during August to mid-September. Sure, in addition to structural factors such as deposit mobilisation in excess of credit flow, there was lower currency demand and pick-up in spending by the government which contributed to the surplus liquidity.</div><div> </div><div>The point is that the average net daily liquidity absorption by RBI (or what banks gave to the RBI) went up from Rs 12,000 crore in July to Rs 26,000 crore in August and to Rs 54,400 in September (up to September 15). Money market rates generally remained below the repo rate. It changed subsequently (as in RBI injected money), but that’s due to technical reasons -- quarterly tax collections went out of the system from mid-September, deficit conditions returned and the Reserve Bank engaged in average net injections of the order of Rs 54,400 crore (September 16th to 27th) which kept call rates close to the repo rate.</div><div> </div><div>Governor Rajan has pleased all and sundry with a repo rate cut – the shrill cries for it will taper off for a while now. The “focus of monetary action for the near term will shift to working with the Government to ensure that impediments to banks passing on the bulk of the cumulative 125 bps points cut in the policy rate are removed”.</div><div> </div><div>Let’s see how that part pans out!</div>
BW Reporters
Raghu Mohan is an award-winning senior journalist with 22 years of experience. He has worked for BW Businessworld since December 2006, and is currently its Deputy Editor. His area of expertise is banking – commercial, investment, and the regulatory. Previous stints include those at The Financial Express and Business India.
