As the mid-quarter monetary policy review due
on September 17 draws near, the usual speculation
about the Reserve Bank of India’s (RBI’s)
action is building up. There is a minority that hopes
that the combination of sub-six per cent growth in
the last two quarters and somewhat lower-thanexpected
inflation rates will persuade the RBI to drop
the policy rate. The majority in the markets, however,
expects no change — particularly in the absence
of any visible efforts by the government to pare the
fiscal deficit or improve the food-supply situation.
However, in fretting endlessly over whether or
not the central bank is likely to cut the policy rate by
a minuscule quarter of a percentage point, we tend
to forget the fact that the interest rate is ultimately
the price of credit — and, like all prices, is determined
by its demand and the supply. Thus, to figure
out where actual lending and borrowing rates are
headed, a quarter of percentage point change in the
repo notwithstanding, it is important to get a handle
on what the balance between the demand and supply
of credit looks like.
At the risk of stating the obvious, let me point
out a couple of things. The supply of credit is the
available pool of deposits in the banking system,
adjusted, of course, for what the RBI takes away in the
form of the cash reserve ratio (CRR) and the statutory
liquidity ratio (SLR). Of the two, the CRR is really
the binding constraint, and the easiest way to influence
the supply and hence the price of credit is to
push the CRR up or down. Given its potency in managing
interest rates, it might not be such a good idea
to abolish it after all.
Second, banks make their money from the difference
between their cost of deposits and other borrowings
and the rate at which they lend. This is the
interest margin. As profit-maximising entities
accountable to their shareholders, it is rational for
them to try and at least protect these margins to the
extent possible. The implication is that banks are
unlikely to drop lending rates sharply unless they are
able to reduce deposit rates. But can they?
A couple of things are important here. First the
supply of deposits relative to credit is fairly tight,
with the credit-deposit ratio at over 75 per cent. To
put this in perspective, it might be useful to look at
previous episodes of sharp cuts in deposit rates. In
the 2001-2003 period, when banks on average
reduced their deposit rates by three and a half percentage
points, the credit-deposit ratio was a little
less than 55 per cent. A similar reduction took place
in the period between 2008 and 2009 when plummeting
credit demand (in the wake of the financial
crisis of 2008) reduced the credit-deposit ratio by a
good five percentage points over a short span of time
This is unlikely to happen this time. Informal surveys
of bankers suggest that they are somewhat comfortable
with the 17 to 18 per cent rate of credit growth
that they see at current lending rates and do not
expect this to reduce dramatically. In fact, credit offtake
tends to pick up in the second half of the year;
come October, the credit-deposit ratio could start
moving up again. Add to this a fairly hefty government
borrowing calendar (and an overrun in borrowings
on the back of a runaway fiscal deficit), and
any potential comfort on the liquidity front could just
about evaporate. In fact, the RBI might have to step
in with both a cut in the CRR and bond purchases
from banks (to release rupees) to restore a balance.
What about the longer term? If the deceleration in
economic activity continues and GDP growth
remains sub-six per cent, it is likely to take a toll on
credit demand. These things work with a lag and
our estimates suggest that it could take at least six to
eight months for weak GDP growth to seep into the
credit market. If loan demand loses traction, banks
will certainly reduce their effort to mop up deposits
and could start lowering deposit rates.
Their response on the lending front might, however,
be far more nuanced. For one thing, given slower
economic growth and the possibility of delinquency,
it might not make sense to hawk more loans
by reducing interest rates. This is particularly true for
intensely cyclical sectors where creditworthiness is
affected the most. I would, for instance, be surprised
to see a rate war among banks in the market for truck
loans in the middle of a severe economic slowdown.
Ditto for things like unsecured personal loans. The
sole beneficiaries in terms of interest rates would
typically be large, financially stable companies
whose cash flows and ability to service loans are relatively
protected from the vagaries of the business
cycle. As banks make a beeline for these “quality”
assets, their rates could come down sharply.
There is another reason why banks might not want
to reduce margins by lowering credit rates to expand
their loan books. Various estimates including the one
released by the RBI in its recent Financial Stability
report suggest that non-performing loans are likely to
spike in 2013 as repayments of loans to vulnerable sectors
like power become due. Banks will have to provide
for these bad debts and that will entail a straight
hit to their bottom lines. To compensate, they will
have to ensure that the profitability on performing
loans does not fall; in fact, they could actually want
this profitability to increase. Thus, the legroom for
drooping margins, and hoping that volume growth in
credit somehow compensates for this against the
backdrop of falling credit demand, is limited.
Banks also need to raise large amounts of capital
to meet their capital requirements especially as the
more stringent demand of Basel-III kick in. The RBI’s
annual report points out that public sector banks
alone will need ~1.75 lakh crore of just equity capital
to meet Basel-III. This would be impossible to achieve
if profitability declines sharply.
The fundamentals of the banking market suggest
that we might be stuck in a relatively high-interest rate
regime for a while. Small cuts in the repo rate might
work wonders for market sentiment but will have
only a marginal impact on actual borrowing costs.
on September 17 draws near, the usual speculation
about the Reserve Bank of India’s (RBI’s)
action is building up. There is a minority that hopes
that the combination of sub-six per cent growth in
the last two quarters and somewhat lower-thanexpected
inflation rates will persuade the RBI to drop
the policy rate. The majority in the markets, however,
expects no change — particularly in the absence
of any visible efforts by the government to pare the
fiscal deficit or improve the food-supply situation.
However, in fretting endlessly over whether or
not the central bank is likely to cut the policy rate by
a minuscule quarter of a percentage point, we tend
to forget the fact that the interest rate is ultimately
the price of credit — and, like all prices, is determined
by its demand and the supply. Thus, to figure
out where actual lending and borrowing rates are
headed, a quarter of percentage point change in the
repo notwithstanding, it is important to get a handle
on what the balance between the demand and supply
of credit looks like.
At the risk of stating the obvious, let me point
out a couple of things. The supply of credit is the
available pool of deposits in the banking system,
adjusted, of course, for what the RBI takes away in the
form of the cash reserve ratio (CRR) and the statutory
liquidity ratio (SLR). Of the two, the CRR is really
the binding constraint, and the easiest way to influence
the supply and hence the price of credit is to
push the CRR up or down. Given its potency in managing
interest rates, it might not be such a good idea
to abolish it after all.
Second, banks make their money from the difference
between their cost of deposits and other borrowings
and the rate at which they lend. This is the
interest margin. As profit-maximising entities
accountable to their shareholders, it is rational for
them to try and at least protect these margins to the
extent possible. The implication is that banks are
unlikely to drop lending rates sharply unless they are
able to reduce deposit rates. But can they?
A couple of things are important here. First the
supply of deposits relative to credit is fairly tight,
with the credit-deposit ratio at over 75 per cent. To
put this in perspective, it might be useful to look at
previous episodes of sharp cuts in deposit rates. In
the 2001-2003 period, when banks on average
reduced their deposit rates by three and a half percentage
points, the credit-deposit ratio was a little
less than 55 per cent. A similar reduction took place
in the period between 2008 and 2009 when plummeting
credit demand (in the wake of the financial
crisis of 2008) reduced the credit-deposit ratio by a
good five percentage points over a short span of time
This is unlikely to happen this time. Informal surveys
of bankers suggest that they are somewhat comfortable
with the 17 to 18 per cent rate of credit growth
that they see at current lending rates and do not
expect this to reduce dramatically. In fact, credit offtake
tends to pick up in the second half of the year;
come October, the credit-deposit ratio could start
moving up again. Add to this a fairly hefty government
borrowing calendar (and an overrun in borrowings
on the back of a runaway fiscal deficit), and
any potential comfort on the liquidity front could just
about evaporate. In fact, the RBI might have to step
in with both a cut in the CRR and bond purchases
from banks (to release rupees) to restore a balance.
What about the longer term? If the deceleration in
economic activity continues and GDP growth
remains sub-six per cent, it is likely to take a toll on
credit demand. These things work with a lag and
our estimates suggest that it could take at least six to
eight months for weak GDP growth to seep into the
credit market. If loan demand loses traction, banks
will certainly reduce their effort to mop up deposits
and could start lowering deposit rates.
Their response on the lending front might, however,
be far more nuanced. For one thing, given slower
economic growth and the possibility of delinquency,
it might not make sense to hawk more loans
by reducing interest rates. This is particularly true for
intensely cyclical sectors where creditworthiness is
affected the most. I would, for instance, be surprised
to see a rate war among banks in the market for truck
loans in the middle of a severe economic slowdown.
Ditto for things like unsecured personal loans. The
sole beneficiaries in terms of interest rates would
typically be large, financially stable companies
whose cash flows and ability to service loans are relatively
protected from the vagaries of the business
cycle. As banks make a beeline for these “quality”
assets, their rates could come down sharply.
There is another reason why banks might not want
to reduce margins by lowering credit rates to expand
their loan books. Various estimates including the one
released by the RBI in its recent Financial Stability
report suggest that non-performing loans are likely to
spike in 2013 as repayments of loans to vulnerable sectors
like power become due. Banks will have to provide
for these bad debts and that will entail a straight
hit to their bottom lines. To compensate, they will
have to ensure that the profitability on performing
loans does not fall; in fact, they could actually want
this profitability to increase. Thus, the legroom for
drooping margins, and hoping that volume growth in
credit somehow compensates for this against the
backdrop of falling credit demand, is limited.
Banks also need to raise large amounts of capital
to meet their capital requirements especially as the
more stringent demand of Basel-III kick in. The RBI’s
annual report points out that public sector banks
alone will need ~1.75 lakh crore of just equity capital
to meet Basel-III. This would be impossible to achieve
if profitability declines sharply.
The fundamentals of the banking market suggest
that we might be stuck in a relatively high-interest rate
regime for a while. Small cuts in the repo rate might
work wonders for market sentiment but will have
only a marginal impact on actual borrowing costs.
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