(Photo: Reuters)
(Photo: Reuters)

RBI’s diktat may not lead to lower rates of lending

  • Banks are looking to earn a higher spread on their loans to cushion impact of a large number of bad loans
  • Banks may also have to move towards floating rate fixed deposits, something that goes against the very idea of fixed deposits. Hence, banks will follow RBI’s diktat in letter, but not in spirit

Last week, the Reserve Bank of India (RBI) issued a circular instructing banks to link all new floating rate retail loans, as well as floating rate loans to micro, small and medium enterprises (MSMEs), to an external benchmark from 1 October. Mint takes a look

What are banks supposed to do?

Banks are supposed to link the interest rate on their floating interest retail loans, as well as floating rate loans to MSMEs, to an external benchmark such as the repo rate of RBI or returns on treasury bills issued by the government. The repo rate is the interest rate at which RBI lends to banks, whereas treasury bills are short-term financial securities with a maturity period of less than a year, issued by the government to finance its fiscal deficit. The interest rates can be reset at least once every three months. The idea is to ensure that lending rates of banks move in line with the repo rate of RBI.

Why is the central bank doing this?

The transmission of the monetary policy of the central bank during this year has been very poor. RBI has cut the repo rate by 110 basis points from 6.5% to 5.4% since January. One basis point is one-hundredth of a percentage point. The weighted average lending rate on outstanding loans of commercial banks operating in the country was 10.38% as of January. By June, this had gone up by five basis points to 10.43%. With RBI cutting the repo rate, the expectation was that bank lending rates will also come down. However, that hasn’t happened. Banks are holding on to their lending rates.

Why have lending rates not come down?

The bad loans of banks, in particular public sector banks, remain high. So banks are looking to earn a higher spread on their loans to cushion the impact of a large number of bad loans.

(Graphic: Paras Jain/Mint)
(Graphic: Paras Jain/Mint)


Why do banks try to earn a higher spread?

The spread, the difference between the weighted average lending rates of banks and the weighted average domestic term deposit rate, was around 3.2% between July 2014 and July 2015. That was the time RBI launched the asset quality review and forced banks to recognize their bad loans. Once this happened, banks started raising their spreads so that they made a higher profit against which they could provision their bad loans and even write them off. The margin has recently fallen, but is still a high 3.59%.

Will interest rates fall with RBI’s move?

Banks may also have to move towards floating rate fixed deposits, something that goes against the very idea of fixed deposits. Hence, banks will follow RBI’s diktat in letter, but not in spirit. They will ensure their mark-up over the external benchmark is high enough to not have an impact on the current spreads they are operating at. Market forces usually find a way to get around diktats they don’t want to follow. This time will be no different.

Vivek Kaul is an economist and the author of the Easy Money trilogy.

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