The Reserve Bank of India (RBI) seems to be settling for repurchase (repo) rate as an external benchmark for directing banks to link their home and car loans for a better transmission of interest rates. When interest rates go up, banks are quite quick to hike the rates. However, when interest rates go down, the transmission is always delayed. In the past, the RBI has shifted from one benchmark to another beginning from prime lending rate (PLR), base rate to currently marginal cost of lending rate (MCLR).
The transmission of interest rates from banks to final borrowers, however, has always remained a big issue. The RBI Governor Shaktikanta Das recently said that banks have transmitted 29 basis points out of 75 basis points cut in the repo rate in the last six months. Earlier this month, the RBI cut repo rate by another 35 basis points to 5.4 per cent, taking the total repo rate reduction to 110 basis points. While new borrowers did get advantage of lower rates, existing borrowers have been left out. In some cases, interest rates have actually gone up for home loan borrowers. Following are a few reasons why the transmission of rates to existing borrowers is taking so long?
Limited borrowing by banks from RBI's repo window
Banks generally avail repo rate borrowings for their daily mismatches or fund shortages. The RBI's repo window provides a ready credit line (currently at 5.40 per cent interest rate) against government securities as collateral. The repo rate borrowing is a small part of banks' cost of funds. Bulk of funds comes from current and savings account, which comprises almost half of funds. Similarly, term deposits, on which banks offer a higher interest rate, also contributes to cost of funds.
These liabilities, especially term deposits, are locked in for at least three to five years. There is a misconception that the repo rate is equal to the cost of funds of banks. The cost of fund is very diverse for banks with each source contributing its share with a certain rate of interest. For example, cost of current account deposits will be zero, while that for savings account will be 3.5-4 per cent. The repo rate borrowing cost would be 5.40 per cent. For any meaningful transmission of rates, especially lower interest rates, the entire cost of funds should come down. In fact, the resetting of rates should be in quick interval for existing borrowers.
Linking deposit rates to repo rate
Currently, a discussion is going on to link the lending rate of banks to repo rate. But, the deposit rate should also be linked with repo rate for better transmission of rates. Banks lend whatever it gets from depositors after keeping its margin. In fact, this is not easy because of competitive pressure and drastic fall in the deposit growth rates because of alternative avenues such as mutual funds and others. The entry of new banks especially small finance banks, payments bank and couple of full-scale banks have created a cut-throat competition in the market.
Depositors are also shopping for higher savings and term deposit rates. The business model of new banks also supports a slightly higher savings and term deposit rates because they are lending to riskier customers, especially non-salaried, micro entrepreneurs and self employed who do not get funds from banking sources. This changed dynamics is coming in the way of faster transmission of rates for existing borrowers.
A likely shift from savings deposits to fixed deposits
Currently, bulk of the cost of funds for a bank comprises current and savings account (CASA). The share of CASA is almost half for big banks. If banks link their savings rate to repo rate, there could be a flight of savings deposits to term deposits of shorter maturity. Lower savings rate is already encouraging depositors to go for term deposits where banks end up paying more than 7 per cent. Take for instance, the SBI is offering 3.5 per cent for savings account whereas term deposit rates for less than a year is at 6.25 per cent.
Protecting margins amid falling profitability and asset quality deterioration
Borrowers complain about non-transparency in the banking system when it comes to interest rates. They are clueless about changes in interest rates. If the overall cost of funds has gone down over the last six months, why are interest rates going up for existing borrowers? There is no answer from banks. Some suggest that banks are protecting their margins by not transferring the benefits of lower interest rates to existing borrowers.
NBFC lending rates don't react to repo rate
The existing borrowers of home and car loan from NBFCs are the worst lot. The entire cost of funds of NBFCs have gone for a toss as banks are not lending or lending at a higher rate. The short-term commercial paper (CP) market is almost shut for them. Non-banking financial companies do not have the advantage of low cost current and savings account. Their borrowing is largely wholesale. The interest rate transmission has not taken place for most of them over the last six months.