RBI move credit negative for banks, says Moody’s

The Reserve Bank of India’s direction to banks to link all new floating rate personal and retail loans, along with loans to micro and small enterprises (MSEs) to external benchmarks with effect from October 1, is credit negative for banks as it will limit their flexibility in managing interest rate risk, according to Moody’s Investors Service.

It said this could cause volatility in net interest margins (NIMs), in turn translating into volatility in the overall profitability of banks.

Also read:RBI’s external benchmark for loans: The good and the bad for borrowers

Under the new rules, the direct linkage between lending rates and funding costs will no longer exist. This will expose banks to asymmetrical movements in the cost of funding and loan yields, exposing them to interest rate risks, said the global credit rating agency.

Linked to MCLR

Currently, banks’ floating rate loans are benchmarked to the marginal cost of funds-based lending rates (MCLR). With changes in lending rates aligned to changes in the cost of funding, banks are able to mitigate their interest rate risk.

Under the new rules, Moody’s said banks will face interest rate risks, as while the floating rate loan book will get re-priced, only the non-CASA (current account, savings account) deposits will see a re-pricing on deposits.

Read more:Pitfalls of external reference for loan rates

This will cause volatility to banks’ NIMs, with NIMs rising when interest rates rise and falling when rates fall. It will translate into volatility in the overall profitability of banks, cautioned the agency.

Srikanth Vadlamani, VP-Sr Credit Officer, and Yustina Quek, Associate Analyst, in a report, said: “It is not clear if banks will be able to mitigate this risk by linking the interest rates on CASA deposits to an external benchmark. With interest rates already low on these deposits, a bank is unlikely to want them any lower as it will risk losing customers.”

Lack of single benchmark

The lack of a single benchmark that can consistently and accurately capture interest rate movements in the economy will also cause volatility to banks’ NIMs, the report said.

The Moody’s officials reasoned that movement in the certificate of deposits rate – seen as a proxy for the average incremental funding rate for the banking system – does not closely track the movement in the Treasury bill rate. Hence, benchmark selection will be difficult and will cause volatility to banks’ NIMs.

Emphasising that banks’ funding requirements are dynamic, the report said there are periods when a particular bank’s funding needs are high, and it will readily pay higher than market rates and vice-versa. The new rules will impede the ability of banks to reflect such changes in funding costs of their lending rates.

“The new rules will be applicable only to new personal, retail and MSE loans. Therefore, the near-term impact will be mitigated as new loans will be a relatively small portion of banks’ loan books to begin with. However, over time, most of the retail and MSE loans will transition to the new mechanism.

“This mandate will affect all rated Indian banks, although in varying ways. For banks with strong deposit franchises, the volatility in interest rates in the economy will have a bigger impact.

“For banks with comparatively weaker deposit franchises, the volatility of their own funding costs will have a bigger impact,” said Moody’s.