Opinion

Tinkering with interest rates is only hurting banks’ sustainability

S Kalyanasundaram | Updated on October 24, 2019

Long-term interest of banks and depositors are being sacrificed for illusory short-term goals   -  istockphoto

With a majority of pricing mandated by the RBI, banks have little room to enhance profitability. Market forces must be allowed to act freely without external influence

Any business entity must strive hard to earn profit by ethical and legal means, for both its own sustainability and to help all the stakeholders. Banks are not an exception. In fact, banks have to manage not only their profitability but also guide their clients to work profitably. Banks do evaluate the prospects of present and future profitability of their clients before extending finance to any unit.

With this being the case, what are the prospects of banks maintaining their profitability under the present circumstances?

After all, banks operate on others’ (depositors) money. To ensure sound functioning, there are regulatory guidelines in place. These help banks maintain liquidity and pay the depositors when needed. But they also put a cap on the lending capability.

Lending provisions

Banks are regulated to maintain a Statutory Liquidity Ratio (SLR) of 18.75 per cent of the deposits by investment in government securities, where the return is low for the banks. They are also mandated to keep a Cash Reserve Ratio (CRR) of 4.00 per cent of their deposits as balance with the RBI, at zero interest.

After the SLR and CRR provisions, banks are left with 77.25 per cent of the deposits mobilised for lending operations. Normally, they maintain a little bit more than the reserve requirement, as the exact requirement cannot be worked out in advance.

Banks are also mandated to lend 40 per cent of their advances priority sector. Interest on priority sector credit is as directed by the RBI, and is far less than the market interest rate. This will take away around 30.90 per cent of the funds.

The banks are then left with 46.35 per cent of their funds. They must earn sufficiently by lending these banalce funds to service all the funds mobilised, as well as to use for administrative/staff expenses.

Low yield rates

Recently, banks have been directed to link their retail credits with the external benchmark. Most have followed this diktat by linking their lending rates with repo rate. It is a different matter that banks get negligible percentage of funds under repo from the RBI, and hence, it is illogical to link lending rate with repo rate.

Initially linking retail loans with repo may help banks keep sufficient spread. But if the repo is reduced in the coming days, the banks will undergo tremendous pressure on their margin. Let us see how:

As on March 29, 2019, gross bank credit was ₹86,74,892 crore, of which personal loans were to the tune of ₹22,20,732 crore. (See Deployment of Gross Bank credit by Major sectors ). This works out to 25.59 per cent of credit. So we can assume that retail loans will be around 26 per cent.

Hence, after a low yield under SLR, zero yield under CRR and a low return of priority sector credit, there is now another mandatory pricing of 26 per cent for personal retail loans. This means that banks can effectively handle only 20 per cent of the deposits mobilised by them to maximise their returns.

 

When pricing of 80 per cent of the portfolio is as directed by the central bank, can we still claim that we are in a deregulated interest environment? When the pricing of the product is predominantly decided externally, how can bank boards be responsible for the profitability?

Banks are in a tight spot. They cannot increase lending interest rate; as the domestic saving rate is already on a declining trend, they cannot reduce the deposit interest rate either. But the government and central bank are still of the opinion that banks must reduce their deposit interest rate further, so that lending rates can also be reduced to benefit borrowers.

The value of rupee is eroded in such a way that if a product was priced at ₹100 in 2008, it would now cost ₹224.63 in 2019. But in 2008, SBI was paying interest of 10 per cent, and now, it pays 6.25 per cent.

Long-term interest of banks and depositors are being sacrificed for illusory, short-term goals. It is important to ensure long-term sustainability of banks by allowing market forces to operate without tinkering with interest rates.

The writer is a retired banker

Published on October 24, 2019

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