With borrowings getting costlier, can banks lend cheaper?

Higher coupon rates on new bond issues by banks will push up the marginal cost of funds even as deposit rates come down


Banks must now price loans with reference to their marginal cost of funds, or the marginal cost of funds based lending rate, according to the RBI’s new directives. Photo: Mint
Banks must now price loans with reference to their marginal cost of funds, or the marginal cost of funds based lending rate, according to the RBI’s new directives. Photo: Mint

Several public sector banks (PSBs) have shored up their capital base by issuing additional Tier I (AT1) bonds in the last few weeks. Coupon rates on these bonds have been high—in the 9.0-11.5% range as per reports. These compare with similar paper (AAA and A+, 5-10 year tenures) that now trades at 7.5-9% according to rating agency ICRA. Cost of capital therefore, is a good 1.5-2.5 points higher. Banks have to refinance their existing Tier I and Tier II capital securities with new, Basel III-compliant ones as the requirements kick in by March 2019. In less than three years time, the old securities will be ineligible for accounting towards regulatory capital. Rating agency Moody’s assess that about $2.5 billion of such legacy securities will either mature or be eligible for recall in 2017.

With no government commitment of recapitalization funds beyond the Rs.70,000 crore ($10.5 billion) up to March 2019 and equity capital not a viable option given low valuations, this is the route taken by PSBs to address their capital requirements. The high premiums demanded by investors for these bonds reflect the increased risks, i.e. lowered market valuations, higher reported losses and resultant reserves’ depletion. Besides, ICRA points out that these bonds are perpetual in nature. So the repayment options vests with the issuing banks, leaving investors reliant upon the secondary market for exit.

Higher costs of source funds bear enormous significance for monetary transmission or the ability of banks to follow the Reserve Bank of India’s easing cues and lower lending rates, a matter that has occupied much policy attention and space for over a year. At this point, with inflation down even more and substantial easing of financial conditions, banks are expected to soon follow suit and reduce interest rates. Last week, the bellwether State Bank of India lowered its deposit rates by 25 basis points; more banks are expected to do the same with a lag. Cheaper deposits, or cost of source funds, will allow banks to lower lending rates in turn as their marginal cost of borrowings declines.

But will it and if yes, how much lower can loan rates decline?

Banks must now price loans with reference to their marginal cost of funds, or the marginal cost of funds based lending rate (MCLR), according to the RBI’s new directives. The MCLR is derived from the banks’ marginal cost of funds, to which the following are added: a negative carry for cash reserves with RBI, operating costs and a tenor premium. The “source of funds” include all types of deposits and borrowings, except equity capital. These have a 92% weightage in calculating the marginal cost of funds, the balance being the return on net worth.

So even if the cost of deposits is trending down, the cost of borrowings through bond issuances is rising. These changes will weigh upon the overall funding costs, depending upon the maturity profile of each bank’s deposits, the distribution of source funds and coupon rates. The net outcome will eventually decide how much banks can really lower the interest rates charged on loans. Note that deposit growth has not been ‘as robust as it should be’ according to a recent statement by the SBI chairperson.

Will the gains on the swing (cheaper deposits) be lost on the roundabout (costlier long-term borrowings)? Though past monetary easing is bringing down deposit rates, the pass-through to interest rates faced by borrowers will surely be affected by the costly capital-raising by PSBs.

It is entirely possible of course that the PSBs may be able to raise cheaper equity capital if valuations improve ahead. This, however, is contingent upon performance, or profitability, which in turn depends upon better health of corporate borrowers as also the stressed assets’ positions, not easily foreseen. Currently, it may be difficult to hope that banks will soon price their loans lower.

Renu Kohli is a New Delhi based economist.

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