Banks need a stiff dose of competition

Recent discussions on the banking sector have centred broadly around three themes: monetary transmission, asset quality in the banking system and consolidation of PSU banks.

In some ways, the three are inter-related. Let’s start with monetary transmission. Before talking about effective/ineffective transmission, let’s try and understand the RBI’s, and possibly the Government’s, concerns. Simply put, less than satisfactory monetary transmission means that reduction in policy rates have apparently not percolated down to the ultimate borrowers in full measure. Now, it is reasonably evident that the RBI, over the last couple of years, has been extremely cautious on inflation and therefore, arguably has been reticent in aggressively cutting rates. At the same, the RBI has been vocally uncomfortable with the pace of monetary transmission.

One can safely argue that what matters for inflation and inflation expectations is not the policy rate/repo rate, but the rate at which borrowers and lenders transact. Assuming that the RBI’s concerns on ineffective monetary transmission are true, they should ironically be rather pleased from an inflation impact standpoint. Why should the RBI then be concerned with poor transmission when their monetary stance itself is at best neutral?

Let us now look at monetary transmission. It is clear that transmission is far more effective in capital markets. CP rates and fresh bond issuances reflect new the interest environment instantaneously. Base rates and to some extent MCLRs are stickier.

A typical bank illustratively would have, on the liabilities side of the balance sheet, approximately 10 per cent as equity (non-interest rate sensitive), 5 per cent tier I / II (non-interest rate sensitive, given long-term fixed rate bonds), 5 per cent medium/long-term borrowings including infrastructure bonds (non-interest rate sensitive, given long term fixed rate bonds), 25 per cent CASA (arguably non-interest rate sensitive, other than the recent savings account rate cut by a few banks), and 55 per cent term deposits (interest rate sensitive with average tenor of say, 1 year). Effectively therefore a reduction in interest rates impacts approximately 55 per cent of the bank’s liabilities and, more importantly, over a one-year period. The rest of the liabilities re-price over much longer tenor.

On the other hand, on the asset side, floating rate loans contribute approximately 50-60 per cent of the assets, the other 40-50 per cent being investments (including mandatory SLR and CRR), corporate bonds/other fixed rate investments and some proportion of fixed rate loan book (largely non-mortgage retail). While, at macro level, the balance sheet appears broadly matched — 50-60 per cent being floating on either side of the balance sheet, the challenge is that fixed deposits take a year to re-price, whereas a cut in benchmark rate (MCLR/base rate) is instantaneous on the entire floating rate loan book, resulting in margin compression for the bank in the short term.

Ironically, given that capital market instruments are not subject to base rate/MCLR regulations, the issuances of CP/ bonds reflect the current interest rates as banks are able to buy/subscribe new deposits reflecting extant interest rates, making transmission instantaneous.

The fundamental challenge here is that there is no true floating rate liability structure for banks. One can argue that banks themselves will have to develop the floating rate deposit product, but customer response, given the complexity and uncertainty for the depositor, has been at best lukewarm. In an environment where the banking system is fighting multiple battles — asset quality, weak growth, challenges on transition to Ind AS accounting practice, rapid digitisation leading to new competition from non-bank players, vulnerabilities in the legacy IT systems — creating a mindset for floating rate deposits hardly appears to be a priority.

In this context, it is clear that MCLRs have largely come down in line with policy rates. Some data indicate that while MCLR has indeed tracked policy rates (especially post demonetisation), as liquidity has been abundant, average lending rates have not yet reflected the fall in MCLR rates. This is simply because MCLR reset happens over a period of time depending on the benchmark MCLR used for sanctioning the loans.

Before jumping to the conclusion that this is a flaw in the structure as the benefit of lower interest rates is significantly lagging, the benefit will be to the borrower when the interest cycle turns. In fact, given that MCLR benchmarks vary from one month to one year, unlike base rate, banks are in a better situation to cut MCLRs, as not the entire book resets immediately. The stakeholders must therefore wait for few more months before concluding on the effectiveness of transmission on eventual lending rates.

Further, common sense would tell us that the best way to ensure competitive lending rates would be through competitive dynamics. One can easily argue that the Indian banking space is already crowded with many public, private and foreign banks. In an environment of single digit credit growth, ideally competition should play its role to bring down interest rates to the end borrowers; then what is at play here?

Clearly, lending rates in general will reflect the lender’s perceived risk profile of the borrower. It is reasonable to argue that the risk perception from a lender’s standpoint has been higher over the last couple of years. This also impacts the lending rate at a macro level though not necessarily at a product level/customer level.

Further, at a time when reported asset quality has sharply deteriorated, banks naturally don’t seem to be in a hurry to cut lending rates. Ideally, cut in lending rates should be driven by competitive dynamics and not through regulatory pressure. How does one then explain then, that when banking sector credit growth in the system is down to single digits amidst tough competition from NBFCs, and disintermediation through capital market issuances, banks don’t seem to be in a hurry to cut rates and grab market share? Most PSBs have significantly elevated asset quality challenges. Given the lack of capital support, undifferentiated business models and inflexible labour practices, ability and intent to grow are absent.

The Government’s strategy of starving inefficient PSBs for capital is laudable, but political courage is required to hasten the process, possibly reduce the shareholding below 26 per cent in select banks, unshackling them from the rigidities of government ownership and, most importantly, recognising that these are independent entities answerable to broader stakeholders, and not only to the Government. Consolidation of state-owned banks with no attempt to address the root issues is possibly just kicking the can down the road.

The writer is an ex-banker

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