4 min read.Updated: 02 Sep 2021, 01:49 AM ISTMadan Sabnavis
Below-cost lending in India could have economic repercussions beyond the financial burden imposed on bank shareholders
We have a situation in India today where the policy repo rate has been kept low, which is reflected in the cost of deposits and consequently lending rates. Getting a home loan at a rate of less than 7%, at a time when the economy appears to be fragile and risk levels are high, is a bonanza. Banks are just about managing their non-performing assets (NPAs) and there is uncertainty in the air. There is talk of loan melas, where credit must be given. The question that arises is whether we are pricing capital adequately.
There are different components of the cost of funds for banks, which is captured by the MCLR or marginal cost of funds-based lending rate. The overnight MCLR is between 6.55% and 7%. The one-year MCLR for State Bank of India is 7% and the median is 7.23% for all banks. To get a grasp of what should be the ideal minimum rate, five components have been considered. The question posed is this: For every ₹100 of deposits that enter the banking system, what are the accompanying costs for the system? These are deposit costs, provisioning for NPAs, return on assets (ROA or minimum profit), and the regulatory cost of cash reserve and statutory liquidity ratio balances (CRR and SLR) that perforce have to be held.
Adding these components (see chart), the basic cost works out to 8.9%, which should be the rate at which incremental lending should take place. By offering loans at a much lower rate of 7.23%, the system is actually mispricing capital. It may be noted that deposit rates have been compressed to a very large degree and so this cost of 4% is very low. Banks do have the advantage of getting free demand deposits and the right to offer differential rates on saving accounts. Clearly, deposit-holders are subsidizing borrowers quite significantly.
The second component is interesting. As NPAs rise, banks must progressively make provisions to cover them. In the past couple of years, provisions as a proportion of NPAs have averaged 30-40% (the chart calculation took the lower rate). As NPAs increase, ideally banks should load this cost onto their borrowers. But that rarely happens in India. Instead, it is taken on banks’ books and gets reflected in their balance sheets. If NPAs were kept in the region of, say, 4-5% of assets, which was the average before the central bank started its asset quality review process, it would have been possible to bring the cost down to 1.5% (from 3%), which would then have justified the present MCLR.
The third part is the ROA. The ideal return norm is 1%, which should be derived from all assets. This does not happen for banks’ investment portfolios, and the value imputed here is only for loans. The curious thing is that the ROA for banks is abysmally low, as this aspect does not go into the pricing of products on the asset side. Deposit costs have been driven down as savers don’t have a choice. But a commensurate return does not materialize in the loan books of banks.
The last part is the carry cost of regulation. The CRR component gets no compensation, while the SLR part earns around 6%, which is the average cost of fresh borrowing for the Union government.
While these numbers vary across banks, the minimum rate of 8.9% would hold for the system. This number, as can be seen, will vary by the level of NPAs. The concept of linking benchmarks to certain loans further misprices fresh lending, as those loans are not ideal anchors to use, for they are being manually driven downwards by a deluge of liquidity in the system after the pandemic.
It has been observed that excess liquidity of ₹4-7 trillion a day since April 2020 has meant banks have been placing funds costing them 8.9% with the central bank through its reverse repo window, which gives them just 3.35%. This is eventually borne by bank shareholders, be it private parties or the government, which is not optimal. In fact, with rather rigid policies on corporate lending to avert possible NPAs, banks have preferred lending to the retail segment, which is less risky, and small businesses, backed by the Centre’s credit guarantee. Also, the central bank’s government-bond buying programme, with earmarked securities purchased from banks to provide liquidity, has been successful. But in the absence of fructification of lending and a continuous rollover of funds at the reverse-repo window, Indian banks are bearing a negative carry trade, with a 6% return traded for just 3.35%.
The worry of capital mispricing is that it spells excessively easy money, which could have repercussions when the chips are down. Banks must price capital appropriately and not get overly influenced by arguments in favour of cheap credit or the fact that loans are cheaper in the West. We need to get practical on this issue.
Madan Sabnavis is chief economist, Care Ratings and author of ‘Hits & Misses: The Indian Banking Story’ . These are the author’s personal views.
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