Next Rate Cut: The ball in banks’ court

When will we see the next round of policy rate cut by the Reserve Bank of India (RBI)? The country’s commercial banks have the answer. As expected, the first bi-monthly policy statement of the Indian central bank, released on Tuesday, maintained status quo in terms of rates, banks’ cash reserve ratio (CRR) as well as mandatory government bond holding but the RBI lobbed the ball in the court of banks. Unless they lower their loan rates, the central bank will not cut its policy rate any more.

In recent past, the RBI cut its benchmark policy rate twice – in January and March – 25 basis points each to 7.5% but banks have not lowered their loan rates. “Transmission of policy rates to lending rates has not taken place so far despite weak credit offtake and the front loading of two rates cuts,” an exasperated RBI has said in its policy statement. One basis point is one-hundredth of a percentage point.

As a regulator, it cannot direct the banks to cut their loan rates but by expressing its helplessness the RBI is possibly seeking intervention of the government, their majority owner, to put pressure on banks for paring rates. For the government, it’s definitely not a happy situation to be in, but it had done so in the past.

To ensure monetary transmission, the RBI wants the banks to compute their base rate or the minimum lending rate on the bases of marginal cost or incremental cost of funds. Till now, most banks compute their base on the basis of average cost of funds besides cost of maintaining the government bond holding and keeping a portion of deposits with RBI in the form of CRR on which they do not earn any interest, overhead costs and expected return on net worth. The base rate is reviewed at least once in a quarter.

Despite the RBI directive to banks to focus on marginal cost of funds instead of average cost or blended cost, most banks seem to be defiant and not in a hurry to cut their loan rates, at least for now. What we are seeing is a rigmarole – RBI wants monetary transmission to happen and banks cut their loan rate as a precondition to the next round of rate cut but banks are unwilling to bite the bullet unless there is ample liquidity in the system, a theory which the central bank is not willing to buy as it feels that there is “comfortable liquidity” in the system.

Only four of 47 lenders have lowered their base rate after RBI cut its policy rate by 50 basis points. Following the cut in policy rate, cost of money has come down in different segments of the market such as government and corporate bond yields and the overnight call money rates. However, these rates have no direct bearing on a bank’s loan rate; banks can pare their loan rates only after they bring down the rates of deposits -- the primary source of money for giving loans. However, the point to note that while a cut in the loan rate affects a bank’s entire loan portfolio and its interest income goes down, a cut in deposit rates is applicable to only the new deposits. In other words, the cost of money does not come down overnight even after paring deposit rates.

Banks’ resistance to cut their deposit rates is not easy to understand as the loan growth has been tardy. In past one year till 20 March, banking system’s credit growth has been only 9.5% while deposit growth has been 11.4% over a larger base. Why do they need deposits when there has hardly been any borrower in sight? Indeed, competing savings instruments at Indian Post Office offer higher rates but those instruments can only attract retail depositors and not corporations who keep bulk deposits with banks. One also cannot understand why banks in India continue to pay 4% on savings bank accounts (some banks even pay 6% and 7%) even when the consumer price inflation dropped to below 5.5%. They were offering the same rate when inflation was 9% and above.

The main reason behind banks’ reluctance to pare loan rates is the pile of bad assets for which they need to set aside money. This affects their profitability. The gross non-performing assets or NPAs of Indian banks had risen to 4.5% of the total advances in September from 4.1% in March, and the net NPAs had increased to 2.5% in the first six months of the fiscal year from 2.2%. The situation worsened in the December quarter and along with restructured assets, stressed loans of the banking system could be around 12% by March. The money set aside by the banks to take care of their bad loans in both September and December quarters is far higher than their collective net profits.

Apart from monetary transmission, the RBI has identified three other factors that will have a bearing on its monetary policy actions in future. They are food inflation, structural reforms by the government to ease supply-side bottlenecks, and the US monetary policy. It has stuck to its January 2016 inflation target of 6% (5.8% by the fiscal year end in March 2016) and 4% by fiscal year end 2018. If unseasonal rains do not lead to escalation in food prices and the monsoon progresses its normal course, the next round of rate cut – and, possibly the last round for the time being – could be on the table in June but it will not happen if the commercial banks stick to their guns and do not cut their loan rates. In the rate cut conundrum, the buck stops at banks.

Tamal Bandyopadhyay, consulting editor of Mint, is adviser to Bandhan Financial Services Pvt. Ltd, India’s newest bank in the making. He is also the author of Sahara: The Untold Story and A Bank for the Buck. Respond to this column at [email protected]

This blog first appeared in www.livemint.com