Our lending rates are actually quite reasonable

Madan Sabnavis | Updated on September 06, 2019 Published on September 06, 2019

There seems to be a high degree of concerted efforts to force banks to lower their lending rates in response to the 110 bps cut in the repo rate. The FM’s assurance that banks have agreed to link their lending rates to the repo rate is testimony to the power of the nudge. But does it make economic sense?

Determining cost

The base rate and the MCLR concepts are well-defined, and hence one can get the benchmark number based on the formula. But how should one look at the basic cost of capital, i.e., the interest rate? The interest rate is the price for capital based on the demand and supply of funds; with the latter being higher today, there is reason for the price to come down. But this is theory.

In practice, there are compulsions from the regulator as well as shareholders, and the final basic cost must reflect these realities. Let us look at different ways of arriving at this number.

In India, if banks have to lend ₹100 they have to raise around ₹130, as 4 per cent of the NDTL has to be kept aside as CRR and 18.75 per cent as SLR. The cost of funds for banks in 2017-18, based on RBI data, was 5.1 per cent, which can be applied to ₹104. For the balance, the difference between return on advances and investments can be applied, as this is the cost of regulation. This was 1.3 per cent, and hence the cost of SLR would be 0.34 per cent. For commercial institutions, the return on net worth of at least 10 per cent can be assumed.

Lastly, a provision for NPAs is also required. Assuming a fair NPA ratio of 5 per cent (although it is 10 per cent today), for the ₹5 of potential NPA on lending of ₹100, a provision norm of 50 per cent would mean a cost of 2.5 per cent. The total cost is shown in the given chart.


This marginal cost can be fine-tuned based on the actual cost for a bank.

Another way of calculating the ideal marginal cost is to take hints from the market. As lending is to the non-government sector, the accompanying pricing by the market gives insights. Here, for example, one can look at how various rates move relative to the repo rate changes. Presently, with the repo rate at 5.4 per cent, the immediate reaction should be seen on GSec yields. The present range of GSec yields are in the region of 6.5-6.6 per cent for the 10-year benchmark used to reckon corporate bond yields. The spread for AAA bonds, which is the best quality of the security that can be raised, is in the region of 100-120 bps. This goes up to 225 bps for AA bonds and 300 bps for A-rated bonds. The latter two can be ignored, and if the spread of AAA is added to the GSec yield, the cost would be 7.5-7.8 per cent.

To this should be added the cost of intermediation, which is what distinguishes the market from the FIs. RBI data for 2017-18 shows this to be 1.85 per cent and hence the overall cost of funds would be 9.35-9.65 per cent.

Now, the present range for MCLR is 7.5-8.4 per cent which is significantly lower than the costs arrived at in these two alternatives, which give similar ranges of 9.35 per cent. There is hence in a way some convergence between the market way of pricing debt and the costing from the point of view of banks.

This really begs the question of how much more banks should be lowering their rates while also maintaining their viability. The critical part to this exercise is that the market is the best judge of the cost of capital, and if GSec yields react in a particular manner, then the bond spreads provide an indication of what the disintermediated market throws up as the cost of borrowing.

Lowering rates

There are hence two aspects here. The first is on how the ‘risk-free price’ moves, which can be driven by other factors besides the repo rate, as is the case today. The second is the risk perception of the top layer of borrowers which is indicated in the spread for AAA companies.

For the realistic cost to come down, both these elements should decrease. If they do not come down, then nudging banks to lower their lending rates may go against the economics of interest rates.

The writer is Chief Economist, CARE Ratings. Views are personal

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Published on September 06, 2019
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