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Why linking deposit rate to external benchmark has to be considered

Madan Sabnavis
deposit rate, external benchmark, commodity prices, regulatory power, higher price, MPC

The price of any commodity should ideally be determined in the market. However, often, there is a preconceived notion of how prices should behave. We want stock prices to go up, commodity prices to come down, exchange rate to be steady, and interest rates to come down. These preconceived notions can, then, have a bearing on actual price if there is regulatory power. Let us see how this works.

When it comes to, say, commodity prices, there is the eternal conundrum of whether the farmer should get a higher price, or the consumer should pay a lower price. Today, while the MPC is happy that inflation is down, the income of farmers has been affected, which has affected spending. The reverse of the two can cause political upheaval. But, there is no control over prices as there are myriad players. The same holds for currency. RBI can intervene in the market, and augment supplies to stabilise the rupee, or, conversely, withdraw dollars to ensure there is no further appreciation. But, being a market-determined rate, RBI cannot force the price in any direction by notification, which was the case in the pre-1992 days.

However, when it comes to cost of capital, there has been constant lament that interest rate transmission is not happening, and while the interest rate is no longer controlled (remember the MLR), the options tried were PLR, base rate, and the multiple MCLR system, where the latter two were formula-driven. With the market not quite being amenable, the mandatory link with a benchmark is the final regulatory push that compels banks to fall in line. Curiously, when it comes to interest rates, just like, say, a farm product, there are two sides, too-a saver and a borrower. The die has been cast in favour of the borrower, who should pay less on loans if the interest rate comes down. Ideally, the choice should have been with banks whether or not to link with benchmarks, but after quite singularly bringing in a regulatory formal-based base rate and MCLR, the benchmark is the third on the book shelf of the library that will now rule the market.

The central bank, as the monetary authority, seems to be better-placed when it has regulated banks to use the market benchmark route as it makes monetary policy more effective. RBI had been expressing its angst against transmission, especially since 110 bps cut in rates did not make banks budge much. Now, there is no choice once a benchmark has been selected. But, interestingly, after the last cut by 35 bps, the 10-year Gsec, which is market-driven, has actually remained intransigent in the 6.5% range, and not come down. Hence, if banks had linked retail loans to the 10-year Gsec, even the latest dictate would not have helped as the lending rate would have remained unchanged, as the market, which is driven by other factors, has not moved in accordance with this change. Hence, there are limits to which the benchmark would work.

How about the banks? They are probably riding the horns of a dilemma. Which benchmark to use? Which loans to include besides retail and SME? As deposits are presently not linked with the benchmark concept (except for a specific bank, which has linked savings rate), how do they manage their liabilities? Linking assets to the benchmark, and not the liabilities will strain the bank's P&L. But, if the deposit rate is also linked to a benchmark in course of time, then customers would be in a quandary as they go in for bank deposits on the assurance of a fixed known return. Now, if it is also made variable, then they would have to bear the volatility in returns, which was not part of their plan. How about the spread over the benchmark, which also has to be anchored for 3 years? If banks want to play safe, they have to choose the benchmark that reacts either the most or least to the repo rate change-Tbill or Gsec, depending on their appetite. The rules are not yet open about whether deposits too can be linked to the same benchmark in phase 2, if, at all, there will be one. This cannot be changed and holds for all customers, and, hence, has to be done with careful thought. Next, the spread over the benchmark should be clear. Here, banks will need to work out their costs, and the possible margins that they would like to maintain, just like what was assumed when working out their MCLRs. This would be the basic lending rate, specified as xxx bps over the benchmark. Wild swings in the benchmark can, however, mean volatility in earnings, especially in a regime of declining interest rates.

How about customers? Intuitively, they would be better off when rates are moving downwards as there would be substantial gains in their EMIs or interest outflows. But, in a rising interest rate scenario, which cannot be ruled out as every economy goes through these phases, there would be challenges in maintaining these outflows. In FY20 so far, the 10-year GSec has moved between 6.45-7.43%, which is almost 100 bps. The 364-day Tbill moved between 5.74%- 6.5%, which is almost 75 bps.

An interesting observation here is that when the financial crisis erupted, which was based on large scale defaults on home loans, it was precisely because the interest rate cycle had turned upwards, and pressurised borrowers, which caused them to default, and leave their homes and keys. While such an occurrence has been looked at today as being a black swan incident as it looks very unlikely that there can be thousands of home owners defaulting at the same time, it is a possibility that cannot be ruled out as interest rates on home loans, which is what is being driven by the government, is going to be variable.

The new interest rate setting model, based on benchmarks, will be a new experience. Hopefully, customers should continue to have a choice of going in for a fixed or floating rate, as it can affect them adversely when the cycle moves up, just as they benefit when it comes down. Also, the critical part of linking the deposits to the external benchmark has to be taken as this one-sided-linkage creates challenges on their interest spreads. As retail and SMEs also tend to move in large numbers, when it comes to response to lower interest rates, and the new dispensation comes in the downward movement regime, the response in upward movements would require close monitoring. From the point of view of monetary policy, this will go down as the final salvo being fired.

(The author is Chief Economist, CARE Ratings Views are personal)