Last week, a day after the Reserve Bank of India, or RBI, raised its policy rate by half a percentage point and banks’ cash reserve ratio, or CRR — the money commercial banks are required to keep with the banking regulator — by a quarter percentage point, India’s second largest state-owned bank, Punjab National Bank, or PNB, announced a full 1 percentage point hike in its lending rate — something unheard of in the history of the country’s public sector banks.
These banks, which have about 70% market share, are never allowed to show aggression by the government — their majority owner — when it comes to raising lending rates. Since the beginning of the fiscal year in April, RBI has raised its policy rate by 1.25 percentage points and CRR by 1.5 percentage points in phases, but these banks have not raised their lending rates.
In June, they merely restored the level of lending rates prevailing early this calendar year when they were forced by the finance ministry to cut the rates even though the banking regulator did not indicate any softening of the rate cycle.
The January development was yet another indication of the growing tension between the finance ministry and the banking regulator on the trajectory of interest rates and the country’s economic growth. While RBI feels that monetary policy should be tightened and interest rate should go up to tame rising prices and burst asset bubbles in certain pockets, the finance ministry has all along been advising banks on offering loans at reasonable rates, as any rate hike will hurt the world’s second fastest growing economy.
Public sector banks have no choice but to listen to the finance ministry that represents the government. In the process, they have unwittingly contributed to the asset bubbles and ignored minority shareholders’ interest as their profitability has taken a hit.
An analysis of listed public sector banks’ first quarter earnings, done by AshwinRamarathinam of Mint’s research bureau, reveals their net profit growth actually dropped by 1.2% in April-June, their worst performance in the past several quarters.
There are quite a few reasons behind this. Since they are not allowed to raise their lending rates, interest income growth has been subdued and the worst in the past six quarters. Besides, there has been some 150% jump in provisions, pulling down their net profit. Provisions have zoomed as the banks had to take care of their growing non-performing assets as well as a huge depreciation in their bond portfolio.
Under banking law, all commercial banks are required to invest 25% of their deposits in government bonds and they need to mark-to-market such investments every quarter. Mark-to-market is an accounting practice of assigning value to a position held in a financial instrument based on the current market price for that instrument. With bond yields rising and prices coming down, banks need to make provisions to take care of their mark-to-market losses.
Private sector banks, too, have been hit by rising rates and tight liquidity, but the impact has been less severe for them, as unlike their public sector peers, they have the freedom to raise their lending rates. So, despite rising provisions, private banks’ net profit for the June quarter rose by some 15%.
By aggressively hiking its lending rate, the Delhi-based PNB has demonstrated rare courage and care for its minority shareholders and the balance sheet, as the only way a bank can remain profitable in a rising interest rate regime is by hiking its lending rates in sync with the market.
It will be interesting to see whether other public sector banks follow the PNB example or buckle under government pressure. Finance minister P. Chidambaram has called a meeting of public sector banks this week to take stock of the situation. He is known for his gentle persuasion in all such meetings against any hike in lending rates.
In the past few years, RBI governor Y.V. Reddy and Chidambaram rarely spoke in one voice on interest rates, and almost every monetary policy action by the banking regulator has been followed by bankers’ meetings in New Delhi where they are persuaded against any hike in their lending rates as they will hurt the apple cart of growth.
There have been occasions when they are forced to roll back their decisions to raise rates and even cut rates to ensure cheap money for borrowers although the direction of the policy rate does not justify such a move.
In his days as banking secretary in the mid-1990s, Reddy, too, often spoke to public sector bank chiefs on phone, asking them to participate in sovereign bond auctions to ensure smooth sailing of the government’s borrowing programme, essential to bridge its fiscal deficit. In banking parlance, this is moralsuasion.
The banks were not shy those days in responding to these overtures as they were wholly owned by the government. But the situation is very different today. If they do not raise their lending rates aggressively, they may find it difficult to survive as interest rates have not yet peaked and a modest hike in lending rates will shrink their business margin.
Indeed, the government is the majority owner of these banks, but they are managed by their boards and the finance ministry cannot dictate banks on how much money should be lent to whom and at what rate. The government has its nominees on bank boards and they can always present the majority owner’s point of view and discuss issues. Directing the chief executive officers on such matters at closed meetings is a violation of corporate governance.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to firstname.lastname@example.org.