Bad loans and the death of the base rate
4 min read 31 Jul 2013, 04:04 PM ISTThe government's tough talk to banks on bad loans and constant prodding to reduce rates smacks of hypocrisy
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While you were not watching, base rate died. Let his soul rest in peace. He was an honourable man, and died a pauper, neglected and unloved.
The autopsy revealed that the patient had several congenital ailments. The final, multiple organ failure was triggered by a seizure caused by something that the doctors did not anticipate—credit quality.
This author has ranted several times against the idea of going the extra mile to keep base rate on a ventilator. With such a multitude of market distortions, including some man-made ones, it was always an exercise in futility.
How can one have such regimentation on lending rates if 23% (and in practise more) of the deposits are compulsorily impounded by the government? A traded, unencumbered, parallel market for loans in the form of commercial paper that sets a different trajectory of rates? The existence of floating funds (equity capital and current account balances) in banks inducing an increase in lending rates quickly on the way up and decrease slowly on the way down? And last but not the least, the repeated directives (by whatever name called) from the government to public sector banks to hold lending rates whenever there is even a feeble sign of an increase? And now, the massive increase in non-performing loans.
That poor asset quality prevents lending rates from declining is not hard to fathom; in fact, the recommended base rate formula can incorporate a normalized (not loan-specific) level of credit loss. But we are not yet conditioned to recognize its importance, because there was a heady, one way improvement in credit quality from 1998 to 2009, and it is only since then that fortunes have reversed. The ecosystem too has done a bad job of eliminating the misconception that base rates have to dance only to the Reserve Bank of India (RBI) policy rate tune; instead, they depend on overall costs of doing business for the bank.
Those of us with longer memories will recollect the furore caused by high bank lending rates when inflation dipped sharply to low single digits after the Asian crisis (remember oil at $10?) and after the tech meltdown (January-May 2002 inflation was 1-2%). Real rates (rates minus inflation) were an outrageous 10-15%. However, banks were helpless and the regulator too grudgingly acknowledged that with the mountain of bad loans that banks were sitting on, lowering rates meaningfully was a tough task.
Things improved in the next five-six years; admittedly there were several other enablers for declining rates, but enhanced credit quality was probably numero uno—bank balance sheets reveal that decrease in provisioning was the single largest contributor to cost reduction during this period (followed by employee costs).
The impact can be gauged by the following simplified example. Slippages (addition to non-performing loans as a percentage of opening loans) have increased from around 2-4% for most banks between 2009 and 2013. At a provisioning rate of 20% (minimum mandated is 15%), this means additional provisioning of 0.4% on loans, approximately 0.3% of the entire balance sheet. Also, a double whammy—bad loans by regulation are not income-accruing, taking away another 0.2% of loans from income (at a loan yield of 10%), about 0.1% of the balance sheet, taking the total pressure to 0.4%. Since the cash reserve ratio (CRR) is at 4% currently, this implies that CRR would have to be reduced to zero to offset the additional provision, weakening the very basis of fractional reserve banking.
The obsession with low base rates also misses an important point. Even if rates were to collapse tomorrow, neither will banks feel encouraged to lend aggressively nor will borrowers queue up just because rates are low, as long as risk perception remains high. We have seen that globally, after the financial crisis, seemingly lower rates have not led to increases in productive lending because risk perception is still elevated. And a cut in the base rate accompanied by an increase in risk premium for the client, as some banks have done, means that the ultimate rate is the same, and in some cases has actually gone up as the increase in risk premium was markedly high.
We would have to wait for risk perception to improve for rates to come down. Anyone who expects that a downward spiral will set afoot immediately after RBI withdraws the putatively temporary rupee-related measures is sure to be disappointed.
The government’s tough talk to banks on bad loans and constant prodding to reduce rates smacks of hypocrisy, apart from damaging the painstakingly created base rate institution. Would it please explain why a disproportionate share of the surge in bad loans has been borne by state-owned banks? Is it anyone’s suggestion that all the bankers of all the 20-odd state-run banks with 25-plus years of experience each, simultaneously made the same poor credit judgements?
But the death of the base rate has not been announced or admitted. Many believe that like God, it cannot die. At least it will take rebirth in a different avatar. We need it.
Dipankar Choudhury is an independent consultant focusing on banks and financial services.
