RBI monetary policy: Interest rates won’t come down unless bad loans are controlled

The third Bi-monthly Monetary Policy Statement for 2015 was released by the Reserve Bank of India (RBI) today (August 4, 2015). As was widely expected, the RBI led by Governor Raghuram Rajan did not cut the repo rate and let it stay at 7.25%. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark for the interest rates that banks pay for their deposits and in turn charge on their loans.

The RBI did not cut the repo rate because the rate of inflation has been on its way up. As the monetary policy statement pointed out: “Headline consumer price index (CPI) inflation rose for the second successive month in June 2015 to a nine-month high on the back of a broad based increase in upside pressures, belying consensus expectations…Food inflation rose 60 basis points [one basis point is one hundredth of a percentage] over the preceding month, driven by a spike in prices of vegetables, protein items – especially pulses, meat and milk – and spices.”

Food prices are something that the RBI cannot do much about. But prices on the whole have been going up as well. As the monetary policy statement pointed out: “Excluding food and fuel, inflation rose in respect of all subgroups other than housing. The momentum of price increases remained high for education. Inflation pressures increased for personal care and effects and household goods and services sub-groups. Inflation in CPI excluding food, fuel, petrol and diesel has been rising steadily since April.” Non food and fuel inflation will continue to go up as the new (and higher) service tax rate of 14% comes into effect June 2015 onwards. All these reasons led to the RBI keeping the repo rate constant.

More importantly, there is an interesting data point that the RBI monetary policy statement reveals: “Since the first rate cut in January, the median base lending rates of banks has fallen by around 30 basis points, a fraction of the 75 basis points in rate cut so far.”

What this basically means is that even though the RBI has cut the repo rate by 75 basis points, the median interest rate at which banks lend money has fallen by only 30 basis points. At the same time, the deposit rate cuts carried out by banks have almost matched the repo rate cut of 75 basis points that has happened so far.

A report in the Mint newspaper points out: “Large lenders such as State Bank of India (SBI), ICICI Bank Ltd, Punjab National Bank, HDFC Bank Ltd and IDBI Bank Ltd started trimming their deposit rates across various maturity periods since October last year, and reduced them by 75-100 bps[basis points].”

If a bank is cutting its deposit rates much faster than its lending rate, it is obviously looking to increase its profit margins. Why is it doing that? The answer in the current case is the bad loans that have been piling up with the Indian banking sector in general and public sector banks in particular.

Data from the RBI’s Financial Stability Report released in June 2015 shows that the gross non-performing assets of scheduled commercial banks in India stood at 4.6% of their total advances, as on March 31, 2015. The number had stood at 4% as on March 31, 2014.

What is even more worrying is the fact that the total amount of stressed advances have jumped significantly over the last one year. As on March 31, 2014, the stressed advances stood at 9.8% of the total advances. A year later this had jumped to 11.1%. The situation in public sector banks is even worse with stressed advances jumping from 11.7% of advances to 13.5%, between March 2014 and March 2015.

The stressed advances number is arrived at by adding the gross non-performing assets (or bad loans) and restructured loans divided by the total assets held by the scheduled commercial banks. Hence, the borrower has either stopped repaying the loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan by increasing the tenure of the loan or lowering the interest rate. This entails a loss for the bank.

What this means is that for every Rs 100 that public sector banks have given out as a loan Rs 13.5 is in dodgy territory. The borrower has either defaulted or the loan has been restructured.

Hence, it is not surprising that banks have been cutting their deposit rates in line with the fall in the repo rate. But their lending rates have not fallen at the same pace. The idea is to increase the profit margin between the cost of borrowing and the cost of lending. This is to ensure that there is enough leeway to account for the bad loans that have been piling up.

If the banks cut their lending rates at the same pace as their borrowing rates, they will either end up with losses or with falling profit levels. Nobody wants that.
Also, banks on the whole have been using the restructuring route to postpone recognising bad loans as bad loans. What this means is that the bad loans of banks (particularly public sector banks) will keep piling up. And hence, the banks will not cut lending rates in line with future cuts in the repo rate as and when they happen.

As one of the deputy governors of the RBI SS Mundra had pointed out in a recent speech: “There has also been an increase in incidence of suits filed against defaulters and cases of wilful default- an unwillingness to pay, despite an ability to pay. These problems could have their genesis in a failure to exercise the right amount of prudence and due diligence on part of the banker or an ab initio intent of the borrower to defraud the bank.”

Also, because of this the trust needed for a banker-borrower relationship to work well has broken down. As Mundra said during the course of his speech: “Recent spurt in instances of forensic audit being conducted by bankers on their borrowers signifies a breakdown in the implicit trust…The banker-borrower relationship is essentially symbiotic as both need each other. Both have certain expectations from the other and when these don’t get fulfilled on account of a malafide or fraudulent intent on the part of either of them, the relationship gets strained.”

This needs to be set right if a meaningful fall in lending rates has to happen. And at the sound of sounding clichéd, this is easier said than done.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column was originally published on August 4, 2015, on Firstpost