Money & Banking

RBI's external benchmark move could put pressure on banks' earnings

Radhika Merwin | Updated on September 05, 2019 Published on September 05, 2019

While the RBI's move is good news for borrowers, it lowers banks’ flexibility on loan pricing

BL Research Bureau

Ever since the RBI started to explore the idea of external benchmarks (to arrive at lending rates), banks have been in a sticky spot, given the impact it would have on their earnings.

While the RBI had deferred the implementation of the external benchmarks (slated from April initially), SBI had taken the lead and linked its savings deposits and short-term loans to the RBI’s repo rate, in May this year. The bank subsequently introduced a repo-linked home loan product in July. As if on cue, other PSU banks have recently came out with loan products linked to the repo rate.

But interestingly, private sector banks had not adopted the external benchmarks up until now. Given that the move would lead to earnings volatility and interest rate risk, private banks have been cagey about rushing into it.

The RBI has now mandated all banks to link their new floating rate personal, retail loans and floating rate loans to MSMEs to an external benchmark effective October 1, 2019. This would lead to higher volatility in earnings for banks, given the low leeway they have on re-pricing deposits.

Banks with a larger proportion of retail and MSME loans will be impacted the most.

Challenges galore

Banks normally lower lending rates, when they are able to cut deposit rates and bring down their costs. But, banks rely significantly on longer term deposits.

Only about a fourth of deposits fall in the less than one-year bucket, as indicated by the aggregate number put out by RBI (individual bank numbers may vary). Hence given that only small portion of deposits get re-priced in the short-term, re-pricing loans in short intervals (three-month reset suggested by RBI under external benchmark), would no doubt hurt banks’ margins.

In the past, unfavourable liquidity conditions, has been a key reason for weak transmission. If a bank is facing a liquidity crunch it is unlikely that it will lower deposit rates in a hurry, even when the RBI reduces its policy rate — as was the case in 2013.

In the April 2012-June 2013 period, while repo rate came down by 125 bps, banks’ deposit rate fell by just 40 bps. Under the RBI’s new external benchmark framework, banks will be forced to lower lending rates, even if they have no relief on the cost front. This will hurt margins.

Also, banks will have to create a portfolio of deposits and loans with a balanced mix across tenors such that the overall asset-liability gaps are managed to mitigate earnings volatility. One way could be to take short-term deposits. So, in a falling interest rate scenario, the banks’ deposits can get re-priced quickly and it can manage its loans getting re-priced quickly. But in such a scenario, bank could run a liquidity gap.

No floating rate deposits

The other way would be to develop floating rate deposits, which has not taken off, as it is particularly difficult to implement it in a falling rate scenario. SBI’s recent volte face on its repo-linked savings deposits, proves just that.

Effective May this year, SBI had linked the interest rate on its savings bank deposits (for balances above ₹1 lakh) with the repo rate. It set savings rate at 2.75 per cent below repo rate.

The RBI’s 35 bps reduction in repo rate in August would have lowered SBI’s savings deposit rate to a very low 2.65 per cent from September. But to ease depositors’ pain, the bank had retained the earlier 3 per cent rate on such deposits.

With no benefit of lower savings deposit rate, SBI’s earnings could get impacted, as it re-prices its loans frequently under the external benchmark framework.

Little flexibility

The RBI has mandated that banks use the same benchmark — repo rate or T-bill yield — for the same category of loans.

While this is good news for borrowers as it will bring in more uniformity and transparency, it lowers banks’ flexibility on loan pricing. Pricing different buckets of loans (based on tenure or size) within a category against different benchmarks, could have helped lower interest rate risk. Also, the RBI has laid down a minimum three-month reset period for interest rate on loans. This further lowers banks’ ability to manage rate risk.

One way to gauge the impact on earnings on account of holding assets and liabilities across different maturities or re-pricing dates is to look at the interest rate risk in the banking book (IRRBB), as disclosed under the Basel requirement by Indian banks.

For instance, as per SBI’s FY19 annual report, for every 100 basis points fall in interest rates, SBI’s earnings (net interest income) will fall by ₹6,014 crore, for ICICI Bank there is an impact of ₹799 crore on net interest income. For Axis Bank, every 200 bps change in interest rates will impact its earnings by ₹1,665 crore.

In general, interest rate risk to net interest income for Indian private and public sector banks have been about 2 per cent to 9 per cent.

Published on September 05, 2019
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