Banks are under pressure from the Reserve Bank of India, or RBI, as well as the government to lower lending rates. Indeed, cheap money can stimulate demand for loans from companies as well as individuals and prop up a slowing economy, but the prime lending rate, or PLR, the rate at which banks lend to their top-rated clients, is no indication of the cost of funds for borrowers. This is because about 70% of borrowers are still accessing money at below PLR.
Between October and March, RBI cut its policy rate by 5.5 percentage points—from 9% to 3.5%—but banks have not reduced their PLR even by half as much. The main reason behind this is their inability to pare deposit rates aggressively, but even those banks that have brought down their deposit rates are reluctant to cut PLR for a structural reason. The industry is by and large deregulated, but a few lending rates are still mandated by RBI and they are linked to banks’ PLR.
For instance, loans to exporters are given at 2.5 percentage points below PLR. Similarly, all loans to small farmers are priced cheaper than PLR. This means that if a bank pares its PLR, its earnings on loans to exporters and small farmers decline drastically. So, banks prefer to keep their PLR at an artificially high level and charge the bulk of their borrowers a loan rate that is much below the prime rate. In other words, PLR is no indication of the actual loan rate that the banks charge their borrowers.
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The best way to force banks to cut their PLR could be to ban the practice of lending below PLR. Since PLR is meant for the top-rated borrowers, they should get bank loans at the prime rate and not below it. Once banks are banned from giving loans at below the prime rate, PLR will come down to 8.5-9% from the current level of around 11.5-12%, almost in sync with RBI’s cut in policy rate. But to do this, the regulator will have to delink export loans and small farm loans from PLR. After all, not all exporters and small farmers are better than banks’ best borrowers. So, banks should be allowed to give loans to exporters and small farmers at PLR and not below PLR. Once this is done, banks will be left with no excuse to keep their prime lending rate at an artificially high level and lend to prime borrowers at below PLR.
It’s also high time RBI looked into some of the mandated rates that hinder banks’ ability to manage their cost of funds. One such rate is the savings account rate, currently pegged at 3.5%. In the past 15 years, the savings bank rate has come down by 1.5 percentage points. In November 1994, it was brought down from 5% to 4.5%. The next two half a percentage point cuts came in April 2000 and March 2003. Since then, it has remained unchanged and banks have no freedom to fix this rate. Any cut in the savings account rate will face political resistance as it affects savers, but RBI can offer banks limited freedom by allowing them to fix the rate within a cap of 3.5%.
A similar cap is used for the deposits kept by non-resident Indians, or NRIs. In this space, RBI should take the next logical step and give banks complete freedom to fix the rate. NRIs keep both rupee as well as foreign currency deposits in India. Banks can pay a maximum 1 percentage point above the London interbank offered rate, or Libor, on foreign currency deposits. For rupee deposits, known as non-resident external, or NRE, deposits, the ceiling is 1.75 percentage points above Libor. Minimum maturity for such deposits is one year. Since one-year Libor is now 1.96%, an NRI earns 2.96% on foreign currency deposits and 3.71% on one-year NRE fixed deposits.
Even though the ceilings on NRI deposits were sharply increased in November after the collapse of Wall Street investment bank Lehman Brothers Holdings Inc. plunged the global financial system into an unprecedented credit crunch, interest rates in absolute terms have not increased significantly as Libor has been dropping following rate cuts by global central banks. With rates turning unattractive, NRIs prefer to invest their savings in the countries where they are living. For instance, interest rates in West Asia are much higher than what Indian banks are paying and a large chunk of NRI deposits come from that region.
Higher insurance cover on deposits is another attraction for NRIs to park their money overseas. US banks haveraised the insurance cover on deposits up to $250,000 (Rs1.25 crore) and banks in Singapore and Hong Kong offer full coverage while Indian banks offer insurance cover on only Rs100,000. No wonder then that between April and January of fiscal 2009, the net outflow of foreign currency deposits almost doubled to $1.2 billion, from $670 million in the corresponding period of the previous fiscal.
The regulator possibly feels that the banking system is not mature enough yet to handle the freedom and that any deregulation of savings account and NRI deposit rates may trigger a rate war among banks and push up their cost of funds. But there is no excuse for not banning sub-PLR loans. It should be done immediately to introduce transparency and tell the world that loan rates in India are not as high as they seem.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as a deputy managing editor of Mint. Please email comments to email@example.com