Lending rates of banks on a historic trail – Did they try to help bank customers and if so, with what results?

It made me speechless when my business friend Mr. N S Nathan, showed his indignation over the high interest rate being charged by his bank though like millions of sincere borrowers, he has kept up with the conditions imposed by the banks. Being an ex- banker with curiosity, my discussions with the economic professors of the Delhi university failed to answer me. Luckily, while referring to the RBI website, I noticed a lecture given by Dr. Viral V Acharya, Deputy Governor, Reserve Bank of India, as Inaugural Aveek Guha Memorial Lecture on Thursday 16th November 2017 at Homi Bhabha Auditorium, Tata Institute of Fundamental Research (TIFR), Mumbai which was titled “Monetary Transmission in India: Why is it important and why hasn’t it worked well?”.

The following article based on above lecture would answer various questions related to high lending rates in banks over nearly two decades, all in simple English.

Many of the bankers’ of 1980s era knew that bankers had to work in tandem and just followed the directives of RBI. Funnily, even the language of the circulars issued by corporate offices of the banks were kept the same. But our loans with IMF changed the course of banking and liberalization of lending rates started flowing.

Since then, the Reserve Bank has made several attempts to improve the speed and extent of the monetary pass-through by refining the process of setting lending interest rates by banks, while at the same time imparting transparency to borrowers and flexibility to banks in the process of interest rate setting.

We have moved from the prime lending rate (PLR) system (1994) to the benchmark prime lending rate (BPLR) system (2003), the base rate system (2010), and the present marginal cost of funds based lending rate (MCLR) system (2016).

Let me explain these systems briefly except the last one, MCLR system which has been covered by my recent article in Tax guru in a detailed manner.

Prime lending rate system-1994

Before we describe what happened in 1994, let us understand how the banks use the internal as well as external macroeconomic factors to decide on lending rates which essentially float to suit the banks’ commercial operations. Let us explain what are the external factors that may affect the lending rate.

Obviously, the first fact to be considered is the inter- bank offer rate or simply the central bank’s policy rate; other considerations may be the certificate of deposit rate, treasury bill or the lending rate offered by other commercial banks. The internal factors include the funds position of the banks, other than being the cushion required by the banks for commercial operations.

The borrowers for the first time had the option of comparing the lending rates offered by the commercial banks for information, a sort of resemblance to Western countries where banks competed with each other to grab the business.

In October 1994, when the Reserve Bank deregulated lending rates for credit limits over ` 2 lakh, banks were required to declare their prime lending rates (PLR) – the interest rate charged for the most creditworthy borrowers – taking into account factors such as cost of funds and transaction costs. The PLR was, thus, expected to act as a floor for lending above Re. 2 lakh.

But, the experience with its working was not satisfactory mainly due to two reasons:

(i) Both the PLR and the spread charged over the PLR varied widely, and inexplicably so, across banks; and perhaps more importantly,

(ii) The PLRs of banks were rigid and inflexible in relation to the overall direction of interest rates in the economy. Public sector banks with virtual monopoly never thought lending is a competitive business requiring adjustments or risk at their ends. Bigger the borrower, the merrier was the attitude. Hence, RBI was forced to think some other options.

In view of these concerns, the Reserve Bank advised banks in April 2003 to announce Benchmark PLRs (BPLRs), taking into account the cost of funds, operational costs, minimum margin to cover regulatory requirements (provisioning and capital charge), and profit margin.

Let us recollect that the cost structure of the public sector banks hardly offered any cushion for the top managements due to the other factors like the salary structure of both the officers and workmen being fixed by the central government due to legal bargain with unions of both the classes, selection of the top managements by the Ministry of Finance with qualifications of the top managements including inclination to finance politically powerful borrowers, and groups which had already entrenched with their past record of availing huge loans and the initiative to acquire new clients was missing.

At that stage, one hardly knows whether Non- Performing Assets were really provided for as per the required norms though RBI had been persisting with consistent policies to remove their ugly heads.

It was noted that the share of sub- BPLR lending was as high as 77 per cent in September 2008, rendering it difficult to assess the transmission of policy rate changes of the Reserve Bank to lending rates of banks. The residential housing loans and the consumer durable loans were outside the purview of the BPLR. As such, sub- 7 BPLR lending became a major distortion in terms of cross-subsidization across borrower categories. One could easily remember the craze among banks to finance these sectors.

Next, the drawbacks of the BPLR system led to the introduction of the base rate system in July 2010. The base rate was also based, inter alia, on the costs of borrowed funds;

An indicative formula for arriving at the base rate was also provided. The base rate was to be kept as the minimum rate for all loans (except for some specified categories) with the actual lending rate charged to the borrowers being the base rate plus borrower-specific charge or spread.

In practice, the flexibility accorded to banks in the determination of cost of funds – average, marginal or blended cost – caused opacity in the determination of lending rates by banks and clarity in lending rates was missing. There was a strong opinion among the customers that new ones were offered the benefits but not the old ones who had been serving the banks honorably.

This also resulted in consternation for the RBI which resulted in the current system, i.e., the MCLR system effective April 1, 2016. Yes, both the current as well as the new borrowers were accommodated among the new system. We have already noted in our earlier article the drawbacks of the MCLR system.

The actual lending rate is based on MCLR plus a spread (business strategy and credit risk premium). It was also observed that the banks never offered any convincing argument for the cushion kept by them on lending rates which virtually made it impossible to understand why the lowering of policy rate under MCLR by RBI did not result in proportional decline in the lending rates of commercial banks. One of the strong argument offered was that the banks with NPAs up- to undesirable limits never wanted to finance new borrowers or were inclined to finance the existing borrowers, however unjustified it could have been in practice. This also made RBI to offer new directions on defaulters’ list and not allowing to finance borrowers with huge NPAs.

RBI deputy Governor thus raised the question “What explains the muted pass-through from policy rate to bank lending rates, either by banks not changing the benchmark rate or by adjusting the spread?”

I could gather the following information from the study conducted by RBI over this issue:

• The fixed deposits which constituted a major portion of bank deposits which constituted 90% of banks’ liabilities side of the balance sheet. Among deposits, fixed deposits with locked in period ranging from 91 days to 5 years and above presented the following picture.

 Deposits profile in various periods:

• % age of deposits and various duration of their stay: up-to 90 days-7%, 91-days-6 months- 4%, 6m-1 year-9.2%, 1-2 years-43.3%, 2-3 years-10.6%, 3-5 years-11.8% and 5 years and above – 14%. This has resulted in rigidity of approach with the banks who had no ways of reducing the interest rates on borrowers. But nearly 40% of bank’s deposits were in the form of low cost current and savings fund account. Even out of this, 31%. of the deposits are from savings fund accounts.
• Importantly, banks have been free to decide saving deposit interest rates since October 2011, but until recently, most of the banks chose to leave the saving deposit rate unchanged, ignoring completely monetary policy signals.
• For instance, the major banks kept their saving deposit rate unchanged at 4 per cent between October 2011 and July 2017, even as the Reserve Bank’s policy rate moved significantly over this period from 8.5 per cent in October 2011 to 7.25 per cent in August 2013. It increased again to 8.0 per cent by January 2014, before declining to 6.0 per cent by August 2017. Enough opportunities were given to banks to act in favor of customers. Interestingly, there was hardly any variation among public sector and private sector banks.
• Furthermore, the deterioration in banking sector health due to worsening of asset quality over the past 2-3 years and the expected loan losses in credit portfolios also seem to have induced large variability in spreads in the pricing of assets. It is strange but true that the increase in cost of financing new borrowers even in small and medium borrowers has actually been directed towards meeting the losses due to the big borrowers.
• Finally, a keen competition from mutual funds and other NBFCs have also reinforced the attitude of banks to offer a reasonably high interest rates even in case of reduction in the rates shown by RBI. People get peace of mind by getting reasonable interest from savings fund accounts at nearly 4% and fixed deposit rates which ranged the highest at 6.3% with many public-sector banks.

The study referred by Deputy Governor, RBI had recommended the following four suggestions that would improve passing the benefits to bank customers in case of reduction in lending rates due to monetary signals indicating reduction in rates.

• The banks to consider only the external bench mark like RBI’s repo rate as the reference point for reducing lending rates.
• The banks have been authorized to have their spread over RBI repo rate but the lending rate to remain fixed during the tenor of the loans unless a major credit event that might occur. It would be left between the banks and the customers to agree on such an event. Banks alone would not decide the matter in any case.
• Third, the periodicity of resetting the interest rates by banks on all floating rate loans, retail as well as corporate, be reduced from once in a year to once in a quarter to expedite the pass-through from the monetary policy signal to the actual lending rates. Unfortunately, the banks have always used prefixing the interest rates on borrowing to benefit the banks alone, so far.
• Fourth, to reduce rigidity on liabilities side, banks be encouraged to accept deposits, especially bulk deposits, at floating rates linked directly to the selected external benchmark. This has never been attempted in Indian banks and would definitely usher in better future in the working of banks. But the underlying principle is to benefit the customer and not the inefficient or banks with high toxic assets. Today’s SBI announcement to raise the interest rate for big customers by 1% is a welcome signal in this respect. But will be variable on quarterly basis?

Conclusion

The recommendations of the study group are available in public domain from October 4, 2017 as per the observation of Deputy Governor in his speech dated 16h November, 2017 and any one interested can give their suggestions directly to RBI study group.

Further the following steps do portend a bright future for reduction in lending rates of borrowers in commercial banks:

• The enactment of the Insolvency and Bankruptcy Code (IBC) in December 2016, the promulgation of the Banking Regulation (Amendment) Ordinance 2017 (since notified as an Act), and the subsequent actions taken there under in the form of the Reserve Bank requiring banks refer the largest, material and aged non-performing assets (NPAs) to the IBC, have made the IBC a lynchpin of the new time-bound resolution framework for bank NPA. Many of the recent articles written by me have already touched this matter.
• The Government’s decision to recapitalize public sector banks in a front-loaded manner, with a total allocation of Re. 2.1 trillion, comprising budgetary provisions (Re. 181 billion), recapitalization bonds (Re. 1.35 trillion), and raising of capital by banks from the market while diluting government equity share (around Re. 580 billion). Apart from offering the public to own much larger share banks’ equity, the common man can easily question the banks’ managements why the benefits are not offered to small and medium level borrowers towards improving their businesses as compared to big borrowers. Right now, he is just a spectator with no voice for raising objections.
• All the statistical information has been taken from RBI website giving authentication to valid arguments.

I firmly believe that the lending rates of commercial banks would be market oriented and would help the borrowers. Also offer of an internationally comparable rate of lending would usher in great growth in our economy. I do request the nominee directors from RBI and Ministry of Finance to play an active role during the meetings of Board of Directors.

Reference- https://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/DGVVAS34AEAD82174B44EA854710B1103E0988.PDF

About the author : Subramanian Natarajan C.P.A. (USA), M.Sc., CAIIB took voluntary retirement in 2000 from Punjab National Bank after handling various facets of banking like deposit mobilisation, foreign exchange, auditing and borrower accounts. After living in USA for 12 years during which period he worked in international auditing firms specialising in international tax, auditing, IFRS etc. He can be reached at subcpa@gmail.com. Tel: 7503562701, 9015613229. He currently lives in Delhi. His name appears as tax consultant in web site of American embassy, New Delhi.