New Delhi-based Punjab National Bank, India’s second largest government-owned bank, last Friday cut its prime lending rate (PLR), or the rate at which it lends to its most creditworthy borrowers, by half a percentage point to 11.50%. The PLR of other public sector banks varies between 12% and 12.5%.
Since October, the Reserve Bank of India (RBI) has cut its repo rate, or the rate at which it lends money to the banking system, by 350 basis points to 5.5% and the reverse repo rate, or the rate at which it absorbs liquidity from the system, by 200 basis points to 4%. One basis point is one-hundredth of a percentage point. The cuts have drastically lowered the interest rate in the overnight call money market from where banks borrow to tide over temporary asset-liability mismatches. Government bond yields, too, have declined. But banks have been reluctant to lower their PLR.
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The main reason behind the reluctance is their inability to bring down their cost of deposits. Till recently, banks were offering at least 10% for one-year deposits. Most of the banks are in the process of bringing down this rate to around 8%. Even after doing this, the cost of deposits won’t come down dramatically overnight as the new rates will be paid only for fresh deposits and banks will have to continue to pay higher rates on existing deposits till maturity. Despite the sharp fall in RBI’s policy rate as well as inflation, banks are finding it difficult to bring down the one-year deposit rate to below 8% for fear of losing money to small-savings schemes run by the government. Most of these schemes offer 8% returns.
Between 2003 and 2008, when Indian stock markets had a dream run, banks were competing fiercely with mutual funds for savers’ money as returns from investments in mutual funds were high and laced with tax advantages. With the stock market now in a firm bear grip, and investors looking for risk-free returns, banks will have to fight it out with small-savings schemes that offer tax benefits. Interest earned on bank deposits is taxable.
The government has in the past tried to address this structural problem, but without much success. Two panels were set up to study small savings rates and the tax benefits they offer—one headed by former RBI governor Y.V. Reddy (in 2001) and another by deputy governor Rakesh Mohan (in 2004). Both the panels recommended linking the rates offered by such schemes to yields on government bonds and treasury bills of comparable maturity. But not much headway has been made as the government does not want to take steps that will affect the flow of money into such schemes, which play a major role in financing the fiscal deficit of both the Centre as well as state governments.
Even after paying 8% for one-year deposits, banks can pare their PLR because they do not pay such high interest rates on their entire deposit base. The interest rate on savings accounts is 3.5% and on current accounts, maintained by companies, nil. Between them, savings and current accounts comprise roughly 30% of total deposits. So banks do not have to hugely compromise on their net interest margin, or the spread between what they pay for deposits and earn on loans, if they bring down their PLR. Anyway, the prime borrowers are charged below PLR even now. At least two state-run oil firms have recently raised short-term money at around 8.5%, 375 basis points lower than most public sector banks’ PLR.
Then why aren’t banks lowering their PLR? Under RBI norms, certain loans are benchmarked to PLR and if it declines, banks’ earnings on such loans are compromised drastically. For instance, loans to exporters are given at 250 basis points lower than PLR. So a bank which has fixed its PLR at 12.25% now offers loans to exporters at 9.75%. If the PLR is brought down to 10%, loans to exporters will be priced at 7.5%. Similarly, all small-firm loans are priced cheaper than a bank’s PLR. Ditto for home loans. Overall, such concessional loans account for between 30% and 35% of a bank’s loan portfolio.
One way of forcing banks to lower their PLR could be to abolish the system of lending at rates below PLR—both to companies with strong balance sheets as well as individuals. If this is done, banks will be able to bring down their prime rate to around 9%.
Indeed, bankers will take the risk of a drastic cut in PLR even if they are not able to bring down their deposit rates by a wide margin because they can always access money from RBI at 5.5% to take care of their temporary asset-liability mismatches. Banks need to offer government bonds as collateral to access funds from RBI. The banking system’s government bond holding is currently close to 29% of deposits. Under the law, banks need to invest 24% of their deposits in government bonds.
As RBI has allowed banks to use 1.5% of their bond holdings to raise money for non-banking finance firms, mutual funds and housing finance firms, banks’ bond portfolio can actually go down to 22.5%. This means that the excess bond holding in the system is currently 6.5%. Banks can raise about Rs2.5 trillion at 5.5% using this route. Quite a comfortable cushion to absorb short-term shocks.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to email@example.com