Banks are facing significant margin pressures despite surfeit of liquidity in the banking system, according to the State Bank of India’s economic research report Ecowrap.

A back of envelope estimate by SBI’s economic research department suggests that the core funding cost of the banking system that includes cost of deposits, negative carry on Statutory Liquidity Ration (SLR) and Cash Reserve Ratio (CRR) and Return on Assets is currently at 6 per cent, while the reverse repo rate is at 3.35 per cent.

Additionally, if the cost of provisions is added to the core funding cost, the total cost comes to around 12 per cent, the report said.

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“Clearly, banks are facing significant margin pressures. This apart, market sources point out that risk premia over and above core funding cost are not fairly acknowledging the inherent credit risk,” said Soumya Kanti Ghosh, Group Chief Economic Adviser, SBI.

The report said the conundrum of weak credit demand and excess liquidity is evident from the average reverse repo at ₹7 lakh crore since April and Government of India cash balances with RBI at ₹3.4 lakh crore.

Is credit risk adequately reflected in pricing?

The report cited the example of 15 years loans, which are being priced at even lower than 6 per cent, linking with repo / treasury bill rates. It emphasised that 10-year Government Security (G-Sec) is currently trading at 6.2 per cent and by the current pricing trends this could even gravitate towards 6 per cent again.

“This anomaly not only negates the concept of tenor premium but may create a material risk with regard to sustainability of such rates in long term, on which borrowers and banks are basing their financial calculations.

“The only good thing is that such pricing war is mostly restricted to AAA borrowers,” Ghosh said.

According to the report, three year term loans are being quoted at close to 4 per cent repo rate and seven year term loans for borrowers below AAA are also quoting a risk premium of 15-20 basis points over the 10 year rates. Working Capital Loans (WCL) are currently being quoted at a notch above reverse repo rate at 3.35 per cent.

Referring to RBI proposing the concept of normally permitted lending limit (NPLL) for specified borrowers, which is meant to nudge them to move towards corporate bonds market, Ghosh felt that this may lose its importance.

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In the current situation, corporate bond rate and bank lending rate are showing huge differential, he said.

CP market: significant churn

Ghosh observed that the commercial paper (CP) market is also witnessing significant churn with banks now almost absent.

“Non-Banking participants like mutual funds who do not have access to RBI Reverse Repo window are creating pricing pressure in CP market as they are sometimes quoting below RBI reverse repo rate.

“In fact, the CP market reflects the huge pricing gap between better and lower rated borrowers,” he said.

Asset Liability mismatch risk

The report underscored that the industry is replacing its long-term debts by very low-priced CP/working capital demand loan (ECDL) and this will obviously act as an enabler once the investment cycle revives. However there is the risk of an asset liability mismatch if the liquidity is withdrawn quickly.

Ghosh said, “As of now, the inflation numbers may not warrant such a decision from RBI, but if core inflation persists in the current range of 6 per cent or above, that might act as a hindrance to continued liquidity abundance.”

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