Lower Interest Rates Good for Govt, Banks and Corporates, Not for Average Indian

The new monetary policy committee which met for the first time over the last two days has decided to keep the repo rate unmoved at 4%. Monetary policy committee is a committee which decides on the repo rate of the Reserve Bank of India (RBI). Repo rate is the interest rate at which RBI lends to banks and is expected to set the broad direction for interest rates in the overall economy.

The RBI has been trying to drive down the interest rates in the economy since January 2019. In January 2019, the repo rate was at 6.5%. Since then it has been cut by 250 basis points and is now at 4%. One basis point is one hundredth of a percentage.
This has had some impact in driving down fixed deposit interest rates of banks. Take a look at the following chart.

The Crash


Source: ICICI Securities, October 3, 2020.

From the peak they achieved between March and June 2019, fixed deposit interest rates have fallen by 170 to 220 basis points.
This in an environment where the inflation has been going up. In March 2019, inflation as measured by the consumer price index was at 2.9%. It had jumped slightly to 3.2% by June 2019. In August 2020, the latest data available for inflation as measured by the consumer price index, had jumped to 6.6%. Meanwhile, fixed deposit rates which were around 7-8%, are largely in the range of 4-6% now (of course, there are outliers to this).

Hence, inflation is greater than interest rates on fixed deposits, meaning the purchasing power of the money invested in fixed deposits is actually coming down.

In fact, interest rate on savings bank accounts, which in some cases was as high as 6-7%, has also come down. Take a look at the following chart.

Another crash


Source: ICICI Securities, October 3, 2020.

Savings bank accounts now offer anywhere between 2.5-3%.

The fall in interest rates is not just because of the RBI cutting the repo rate. A bulk of this fall has happened post the covid breakout. Banks haven’t lent money post covid.

Between March 27 and September 25, the outstanding non-food credit of banks has fallen by 1.1% or Rs 1.1 lakh crore to Rs 102 lakh crore. This means that people and firms have been repaying their loans and net-net in the first six months of this financial year, banks haven’t given a single rupee of a fresh loan.

Banks give loans to Food Corporation of India and other state procurement agencies to buy rice and wheat directly from the farmers. Once these loans are subtracted from overall lending by banks, what remains is non-food credit.

During the same period, the deposits of banks have risen by 5.1% or Rs 6.97 lakh crore to Rs 142.6 lakh crore. With people saving more, it clearly shows that the psychology of a recession is in place.

Banks have not been lending while their deposit base has been expanding at a rapid pace. The point being that banks are able to pay an interest on their deposits because they give out loans and charge a higher rate of interest on the loans than they pay on their deposits.

When this mechanism breaks down to some extent, as it has currently, banks need to cut interest rates on their deposits, given that they are not earning much on the newer deposits. This is bound to happen and accordingly, interest rates on fixed deposits have fallen.

While the supply of deposits has gone up, the demand for them in the form of loans, hasn’t. This has led to the price of deposits, which is the interest paid on them, falling.

But there is one more reason why interest rates have fallen. There is excess money floating around in the financial system. The RBI has printed money and pumped it into the financial system by buying bonds from financial institutions.

This excess money has also helped in driving down interest rates. While banks haven’t been able to lend at all in the first six months of the year, the government borrowing has gone through the roof. As the debt manager of the government, the RBI has printed and pumped money into the financial system to drive down the returns on government bond, in the process allowing the government to borrow at lower interest rates. Take a look at the following chart, which plots the returns (or yields) on 10-year bonds of the Indian government.

Going down

Source: Investing.com

The yield on a government bond is the return an investor can earn if he continues to own the bond until maturity. The above chart clearly shows that as the government has borrowed more and more through the year, the interest rate at which it has been able to borrow money has come down, thanks to the RBI and its money printing.

Of course, with banks not lending on the whole, they are happy lending to the government. In fact, in his speech today, the RBI governor Shaktikanta Das said that the central bank planned to print and pump another Rs 1 lakh crore into the financial system in the days to come.

With more money expected to enter the financial system the 10-year government bond yield fell from 6.02% yesterday (October 8) to 5.94% today (October 9), a fall of 8 basis points during the course of the day.

The monetary policy committee also decided to keep the “accommodative stance as long as necessary”, with only one member opposing it. In simple English this means that the RBI will keep driving down interest rates as long as necessary “at least during the current financial year and into the next financial year – to revive growth on a durable basis and mitigate the impact of COVID-19 on the economy.”

The assumption here is that as interest rates fall people will borrow and spend more and corporations will borrow and expand more. This will help the economy grow, jobs will be created and incomes will grow. While, this sounds good in theory, it doesn’t really play out exactly like that, at least not in an Indian context.

Let’s take a look at this pointwise.

1) A bulk of deposits in Indian banks are deposited by individuals. In 2017-18, the latest data for which a breakdown is available, individuals held around 55% of deposits in banks by value. This had stood at 45% in 2009-10 and has been constantly rising. Hence, it is safe to say that in 2020-21, the proportion of bank deposits held by individuals will clearly be more than 55%.

When interest rates on deposits (both savings and fixed deposits) go down individuals get hurt the most. There are senior citizens whose regular expenditure is met through interest on these deposits. When a deposit paying 8% matures and has to be reinvested at 5.5%, it creates a problem. Either the family has to cut down on consumption or start spending some of their capital (the money invested in the fixed deposit).

This also disturbs many people who use fixed deposits as a form of long-term saving. The vagaries of the stock market are not meant for everyone. Also, in the last decade returns from investing in stocks haven’t really been great.

2) When interest rates go down, the families referred to above cut down on consumption and do not increase it, as is expected with lower interest rates. This may not sound right to many people who are just used to economists, analysts, bureaucrats, corporates and fund managers, mouthing, lower interest rates leading to an increase in consumption all the time. But there is a significant section of people whose consumption does get hurt by lower interest rates.

3) It’s not just about bank interest rates going down. Returns on provident fund/pension funds which hold government bonds for long time periods until maturity and post office schemes (despite being higher than banks), also come down in the process.

4) Also, no corporate is going to invest just because interest rates are low right now. Corporates invest and expand when they see a future consumption potential. This is currently missing. Also, banks lending to industry peaked at 22.43% of the GDP in 2012-13. It fell to 14.28% of the GDP in 2019-20. During the period, interest rates have gone up and down, but corporate lending as a proportion of the GDP has continued to fall. So clearly increased borrowing by corporates is not just about interest rates.

But corporates love to constantly talk about high interest rates as a reason not to invest. This is just a way of driving down interest on their current debt.

As former RBI governor Urjit Patel writes in Overdraft:

“Sowing disorder by confusing issues is a tried-and-trusted, distressingly often successful routine by which stakeholders, official and private, plant the seeds of policy/regulation reversal in India.”

One can understand interest rates going down in an environment like the current one, but there is a flip side to it as well, which one doesn’t hear the experts talk about at all. Also, anyone has barely mentioned the excess liquidity in the financial system, which currently stands at Rs 3.9 lakh crore. Why is that? Let’s look at this pointwise.

1)  The equity fund managers love it because with interest rates going down further, many investors will end up investing money in stocks despite very high price to earnings ratio that currently prevails. The price to earnings ratio of the Nifty 50 index currently is at 34.7. This is a kind of level that has never been seen before.

But with post tax real returns from fixed deposits (after adjusting for inflation) in negative territory, many investors continue to bet on stocks, despite the lack of earnings growth.

2) The debt fund managers love it because interest rates and bond prices are negatively related. When interest rates come down, bond yields come down and this leads to bond prices going up. This means that the debt funds managed by these fund managers see capital gains and their overall returns go up. Hence, debt fund managers love lower interest rates.

3) Banks invest a large proportion of the deposits they gather into government bonds. When bond yields fall, bond prices go up. This leads to a higher profit for banks. This in an environment where banks aren’t lending. Hence, bankers love lower interest rates.

4) Corporates love lower interest rates at all points of time, irrespective of whether they want to borrow or not. I don’t think this needs to be explained.

5) The government loves low interest rates because it can borrow at lower rates. Second, with the stock market going up, it can sell a positive narrative. If the economy is doing so badly, why is the stock market doing well?

6) This leaves economists. Economists love lower interest rates because the textbooks they read, said so.

The question is do lower interest rates or interest rates make a difference when it comes to borrowing by an average Indian? Let’s take a look at non-housing retail borrowing from banks over the years. In 2007-08 it stood at 5.34% of the gross domestic product (GDP). In 2019-2020, it stood at an all-time high of 5.97% of GDP.

In a period of 12 years, non-housing retail borrowing from banks, has barely moved. What it tells us to some extent is that the idea of taking on a loan to buy something (other than a house), is still alien to many Indians.

So, the idea that interest rates falling leading to increased retail borrowing is a little shaky in the Indian context.

To conclude, today the RBI governor Shaktikanta Das gave a speech which was more than 4,000 words long. In this speech, the phrase fixed deposit interest rate did not appear even once.

A whole generation of savers is getting screwed (for the lack of a better word) and the RBI Governor doesn’t even bother mentioning it in his speech. The RBI seems to be constantly worried about the interest rate at which the government borrows.

A central bank which only bats for the government, corporates and bond market investors, is always and anywhere a bad idea.

Shaktikanta Das’ RBI is at the top of this bad idea.

 

The ‘GULZAR’ Principle of Investing for Regular Income and Safe Returns

Summary: There is no real way of earning a regular and a safe income that is enough to meet the monthly expenses.

The headline was a clickbait. But now that I have your attention, let me explain the logic behind it.

The title song of the 1979 Hindi film Gol Maal was written by the lyricist Gulzar (Honestly, calling him just a lyricist is doing his talent a great disservice. Other than being a lyricist, he has written screenplays and dialogues for a huge number of Hindi films. He is a poet and a short story writer. He is also a translator of repute. Oh, and he has also directed a whole host of Hindi movies as well as a few TV serials along the way. Also, for the millennials, Hrishikesh Mukherjee made Gol Maal, much before Rohit Shetty started using the title for everything he could possibly think of).

Now getting back to the point I was trying to make. In the title song of Gol Maal there is a line which goes: “paisa kamane ke liye bhi paisa chahiye,” essentially meaning, in order to earn money, you first need money. And that is what I am going to write about today.

In the twenty months, as the economy has gone downhill, people have been getting in touch with me on email and the social media, with a very basic financial query. The numbers were small first but post-covid this has turned into a deluge. The question being asked is how a reasonable monthly income can be generated from savings, without taking any risk, in a safe way.

The answer to this question has become very important as people have lost their jobs or seen their salaries being slashed and incomes falling. What does not help is the fact that the post-tax return from bank fixed deposits are now largely in the range of 4-5%. The inflation as measured by the consumer price index is close to 7%.

Before I try answering this question, it is important to understand why interest rates on bank fixed deposits have fallen. The simple answer to this lies in the fact that there is too much money floating around in the financial system, with the banks not knowing possibly what to do with it.

Between March 27 and July 31, a period of little over four months, the non-food credit given by banks has contracted by Rs 1.32 lakh crore or around 1.3%. The banks give loans to the Food Corporation of India (FCI) and other state procurement agencies to primarily buy rice and wheat directly from the farmers at the minimum support price declared by the government. Once these loans are deducted from the overall loans given by banks, what remains is non-food credit.

What does non-food credit contracting tells us? It tells us on the whole borrowers have been repaying loans and at the same time not taking on enough new loans. It also tells us that banks are reluctant to lend. Further, as we shall see, there has been a huge surge in fixed deposits with banks, as people have increased their savings in the aftermath of the spread of the covid-19 pandemic. Banks will take time to lend all this money out.

Between March 27 and July 31, the total deposits of banks have gone up by Rs 5.95 lakh crore or 4.4%. In an environment, where the non-food credit of banks has contracted whereas deposits have jumped big-time, it is but natural that interest rates on fixed deposits have fallen. In fact, the weighted average term deposit interest rate or simply put average fixed deposit interest rate has fallen from 6.45% in February to 6% in June, the latest data available. Now that we are in August, the interest rates may have possibly fallen even more.

In fact, there is nothing new about interest rates on fixed deposits falling, this has been going on for close to eight years now. Having said that, interest rates shouldn’t be looked at in isolation, it is important to compare them with the prevailing rate of inflation. Take a look at the following chart. It plots the average interest rate on fixed deposits during the course of a year, along with inflation as measured by the consumer price index. The difference between the two is referred to as the real rate of return on fixed deposits.

Interest v/s Inflation


Source: Reserve Bank of India.

What does the above chart tell us? Between 2014-15 and 2018-19, there was a healthy difference between the average interest paid on fixed deposits and inflation. (Of course, this is without taking tax on fixed deposit interest into account, else, the difference would have been lower).

These were the years when first Dr Raghuram Rajan and then Dr Urjit Patel were at the helm at the Reserve Bank of India. In 2019-20, the real return on fixed deposits narrowed to 1.6%. Shaktikanta Das took over as RBI Governor in December 2018.

Let’s take a look at the real return on fixed deposits month wise since December 2018, the month when Das took over as RBI Governor. The real return on fixed deposits as explained earlier is the average interest rate on fixed deposits minus the prevailing rate of inflation.

Crash in real returns


Source: Author calculations on data from the Reserve Bank of India.

This chart is as clear as anything can get. The real rate of return on fixed deposits has simply collapsed since end of 2018. This has happened as the interest rate on fixed deposits has fallen and inflation has gone up.

The interest rate on fixed deposits has fallen primarily because the rate of loan growth for banks has crashed over this period. This we can see from the following chart.

Loan growth crash


Source: Reserve Bank of India.

The above chart clearly tells us that the loan growth of banks has crashed since December 2018. In fact, for the week ended July 31, it stood at just 5.4%. Given this, the Indian economy was slowing down even before covid-19 pandemic struck.

Hence, as economic growth has slowed down, the loan growth of banks has slowed down and this has led to fixed deposit interest rates coming down as well. The point being that in economics everything is linked.

Of course, there is more to this than just the economy slowing down. Since February,  like the rest of the central banks, the RBI has printed and pumped money into the financial system to drive down interest rates, in the hope of getting businesses and people to borrow more.

Also, with collapse in tax revenues, the government will have to borrow more this year, in order to keep its expenditure going. Hence, it likes the idea of borrowing more at lower interest rates. The RBI goes along with this because among other things it also acts as the debt manager of the government.

The problem is that India’s economic crisis has grown worse since the covid pandemic hit the world, leading to a lot of individuals losing their jobs or facing salary cuts. Small businesses have been majorly hit and incomes have come down dramatically.

In this environment, people are now looking to generate some sort of a regular income from their savings. Of course, most them want to do this in a risk free way. As one gentleman recently asked me: “I am currently not employed after having worked in the corporate sector for 10 years. My request to you is to honestly guide me on how and where to invest to earn steady income especially when the fixed deposit interest rates have fallen so low.”

The first thing I can clearly say is that the gentleman believes that there is a solution to his problem. He believes that it is possible to generate a good steady income despite fixed deposit interest rates having fallen.

I see this belief among many people. My guess is, it stems from the fact that way too many personal finance publications believe in offering solutions to everything. I mean, why will a reader read you, if at the end of it you say something like there aren’t really any solutions to this problem that you might have. At least, that’s how their thinking operates. Also, they need advertisers. And advertisers love solutions to everything, even when none really exist.

In June 2020, the average rate of interest on a fixed deposit was 6%. Once we take income tax into account, the rate of return would be much lower. Of course, there are banks out there which are offering a rate of interest of 7% or more. Nevertheless, these banks are perceived to be among the riskier ones. So, the question is are you willing to take on more risk, for a 1-1.5% higher return? If yes, then these investments are for you.

While, we live in an era where no bank is going to go bust, they can and have been put under a moratorium or periods under which only a limited amount of money can be withdrawn from them. And money that can’t be spent when it is needed, is essentially useless. Hence, if you do end up putting money in a bank which offers a 1-1.5% higher return, do remember not to put all your money into it.

There are corporate fixed deposits which offer a slightly higher return but again they don’t have the same safety as a bank does.

If you are senior citizen, you can look at the Senior Citizens Savings Scheme. But that comes with the pain of dealing with the post office.

Debt mutual funds as many people have found out over the last one year, come with their own share of risks. They were marketed to be as safe as fixed deposits, but they weren’t anywhere close. Also, irrespective of what financial planners and wealth managers might say, debt mutual funds are fairly complicated products, which I am sure most people selling them don’t understand. And that’s why they are able to sell them in the first place.

A lot of individuals in the last few months have turned towards investing in stocks. The logic is that the stock market has rallied from its March low. On March 23, the BSE Sensex, India’s premier stock market index was at 25,981 points. Yesterday, August 26, it closed at 39,074 points, a jump of over 50% in a period of a little over five months. This rally has been driven by a few stocks and if you had invested in the right stocks, you would have ended up with good gains by now.

While, one can’t question this logic, but what one needs to remember is that on January 12, the Sensex was at 41,965 points. From there to March 23, it fell by 38% in a little over two months. The point being the stock market can fall as fast or even faster than it can rise. Also, do remember this basic point that a 50% fall can wipe off a 100% gain. (A 38% fall would have written off a 61% gain).

Hence, the larger point here as I mentioned in this piece I wrote a few days back is, just because an investor takes a higher risk by investing in stocks, it doesn’t mean he will always end up with higher returns, precisely the reason the word ‘risk’ is used in the first place. And by the way, the 10-year return on stocks (including dividends) is less than 9% per year.

So, the question is what should a person looking for a regular and safe income, actually do? As helpless as it might sound, there aren’t many options going around beyond the humble fixed deposit, especially for people who aren’t senior citizens. The trouble is the fixed deposit interest rates are at very low levels.

If you need to generate a monthly income of Rs 20,000 at 6% per year, this needs an investment of Rs 40 lakh.

The moral of the story here being that if you want to generate a regular safe income which is enough to meet your monthly needs, you need to invest more money. Or as Gulzar wrote in Gol Maal: “paisa kamane ke liye bhi paisa chahiye.” I would like to call this the Gulzar principle of investing for a regular income and safe returns.

Also, there are corollaries to this. These are very difficult times. Hence, there is a good chance of individuals ending up in a situation where they might have to spend their savings (rather than just the return on savings) to keep meeting expenditure.

Let’s take the example of a middle-class household with monthly expenses of Rs 50,000. In order to generate this income through a fixed deposit, an investment of Rs 1 crore is needed. Of course, the chances of a middle-class household with expenses of Rs 50,000 per month having savings of a crore, are rather minimal. In this scenario, they will have to resort to spending their savings. Given this, as I keep saying, the return of capital is much more important now than the return on capital.

In the short run, the only way to generate a good regular and safe income is find a job or any other source of income by selling the skills that one has (Like I write. I can do that for a media house or do it individually). In the long run, the next time you see interest rates of 8-9% available on fixed deposits or any other safe investment, invest in these assets and lock in the high returns for as long as possible.

While, this might not sound much like a solution but that is the long and the short of it.

What do higher household financial savings tell us about the economy?

The household financial savings, which form a bulk of the overall savings in the Indian economy, went up in 2019-20. This after they had fallen in 2018-19. The question is how did this happen and what does this mean for the Indian economy in the post-covid world? Mint takes a look.

What was household financial savings rate in 2019-20?

Household financial savings essentially refers to the savings of households in the form of currency, bank deposits, debt securities, mutual funds, insurance, pension funds and investments in small savings schemes. The total of these savings is referred to as gross household financial savings. Once the financial liabilities, that is, loans from banks, non-banking finance companies and housing finance companies, are subtracted from the gross savings, what remains is referred to as net household financial savings. The net household financial savings in 2019-20 rose to 7.7% of the GDP from 7.2% in 2018-19. This primarily happened because the liabilities fell from 3.9% of the GDP in 2018-19 to 2.9% in 2019-20.

What explains this uptick in household financial savings?

The gross financial savings of households in 2019-20 stood at Rs 21.63 lakh crore, marginally better than the gross savings in 2018-19 which was at Rs 21.23 lakh crore. Nevertheless, the net financial savings jumped to Rs 15.62 lakh crore in 2019-20 from Rs 13.73 lakh crore, a year earlier. This was primarily because the financial liabilities reduced from Rs 7.5 lakh crore to Rs 6.01 lakh crore. This pushed up net financial savings. Why did this happen? This happened primarily because the Indian economy has been slowing down from start of 2019. The per capita income in 2019-20 grew by just 6.1% (nominal terms, not adjusted for inflation), the slowest since 2002-03, when it had grown by 6.03%.

How did slow growth in per capita income impact savings?

A double digit growth in per capita income has happened only once since 2013-2014. In 2016-17, the per-capita income grew by 10.39%. Over the last few years, income growth has slowed down, and in 2019-20, it slowed down dramatically to 6.1%. This has led to a slowdown in lending growth. The non-food credit growth of banks in 2019-20 was at 6.7%, the slowest in more than a decade.

What does this tell about the overall state of the economy?

A slowdown in income growth has led to a slowdown in consumption as well as a slowdown in loan growth. What hasn’t helped is the weak financial state of non-banking finance companies, which has added to the lending slowdown. Also, this means that people were looking at their economic future bleakly, even before covid-19 had struck. At an individual level, the good part for them is that they tried to go slow on their borrowing in comparison to the past. But at the societal level, this hurt the economy because it led to a consumption slowdown.

Where will the household financial savings settle in 2020-21?

The period between April and June will lead to higher savings. As a recent RBI research paper states, a spike in household financial savings “is likely in the first quarter of 2020-21 on account of a sharp drop in lockdown induced consumption.” In fact, this explains why bank deposit rates have fallen in the recent past. The money deposited with banks has gone up, while the banks are unable to lend. But this spike in savings is likely to taper in the months to come simply because of “lags in the pickup of economic activity”.

A slightly different version of the piece appeared in the Mint on June 15, 2020.

Who is Benefitting from Lower Interest Rates?

 

scissor

Over the last one year, bank interest rates have fallen majorly, at least in theory (it will become clear later in the column, why I say this). The question is, who is benefitting from the lower interest rates? The savers, whose fixed deposits have matured, have had to reinvest them at significantly lower interest rates. This includes retirees who have seen interest rates on their deposits, fall from nine per cent to six per cent in a short period of time. In the process, their incomes have crashed by a third. Not surprisingly, they are having a tough time.

People have suggested that senior citizens should invest with the post office where higher interest rates are on offer. Anyone who has actually invested money with the post office for generating a regular income, would never suggest anything like this. Their service levels are abysmally low. They can give a thorough run around to anyone looking to get paid regularly on the investment he has made with the post office.

In fact, I know of several retirees who have reluctantly moved their investments into mutual funds (both equity and debt), given the low after-tax returns on fixed deposits. Even if the returns on mutual funds are the same as bank fixed deposits, the different tax treatment for both these forms of investing, helps generate higher after-tax returns in case of mutual funds.

This investing strategy has worked well for retirees in the last one year, given that the stock market has rallied massively. Nevertheless, is this a sustainable strategy in the long-term for anyone who is looking to generate a regular income out of his accumulated corpus, given the volatility that comes with investing in a mutual fund?

In a country with almost no social security and a health care system which keeps getting expensive by the day, this is a fair question to ask.

Another set of savers who has lost out due to low interest rates are people saving for their future, the wedding and education of their kids, and their own retirement. These people now need to save more in order to meet their long-term investment goals. Of course, these people still have the option of discovering the power of compounding by investing in mutual funds through the systematic investment plan (SIP) route.

But given the abysmal levels of financial literacy that prevail in the country, the chances that they will be mis-sold a unit linked insurance plan(ULIP) by a private insurance company or an endowment or a money-back policy by Life Insurance Corporation of India, remain very high. These forms of investing remain the worst way you can invest your money.

Also, consumption growth and interest rates are closely linked. Conventional economic logic tells us that at lower interest rates people borrow and spend more, and this increases private consumption growth and in turn helps economic growth. QED.

While that may be true for developed countries, it doesn’t quite work like that in India. In India, if interest rates fall, the retirees need to cut down on their regular expenditure because their regular income also falls. People who are saving for the long-term also need to save more in order to meet their investment goals.

Given that most household financial savings get invested in fixed deposits, a fall in interest rates makes people feel less wealthy and this has an impact on their consumption. Due to these reasons people end up cutting down on their expenditure. This is reflected to some extent in Figure 1, which plots the growth in private consumption expenditure over the last few years.

Figure 1: 

As interest rates have fallen through 2017, the growth in private consumption expenditure has collapsed from 11.1 per cent to 6.5 per cent. As of December 2016, private consumption expenditure formed 59 per cent of the Indian gross domestic product. Since then, it has fallen to 54 per cent. So, much for lower interest rates.

There are two sides to interest rates, the saving side which I was talking about up until now, and the borrowing side, which I will talk about in the remaining part of this column.

The total non-food lending carried out by Indian banks has actually contracted during this financial year. But weren’t lower interest rates supposed to help increase lending? Now only if economic theory and reality played out same to same, the world would be such a different place.

Banks are extremely quick to cut interest rates on their fixed deposits, as well as raising interest rates on their loans. Nevertheless, the same cannot be said about a situation where they need to pass on the benefit of lower interest rates to their borrowers.

Let’s take the example of people who have taken on home loans from banks as well as housing finance companies. Over the last one year, the interest rate on a home loan has fallen from 80 to 100 basis points. One basis point is one-hundredth of a percentage.

The trouble is in many cases the banks and the housing finance companies haven’t bothered to inform the borrower, about the lower interest rate. And the borrower has unknowingly continued to pay the higher EMI. This never happens when the banks and the housing finance companies need to raise interest rates on their home loans. In that case, the letter/sms/email arrives right on time.

In fact, I have heard cases where people have pointed this dichotomy out to a leading housing finance company, and they have been told that they are expected to come to the office of the housing finance company and keep checking. So much for market competition which is supposed to lower interest rates. Of course, the stock market rewards such companies with a higher price to earnings ratio, given that they can do these things, get away with it, and make more money in the process.

The media which is quick to announce lower EMIs whenever RBI cuts the repo rate, never goes back to check whether EMIs have actually fallen. This is simply because it is easier to take the theoretical way out and announce lower EMIs when RBI cuts the repo rate, whereas actual checking would involve doing some legwork and speaking to banks, housing finance companies and borrowers. And who wants to work hard? It’s worth pointing out here that banks are huge advertisers in the media.

The question is when higher interest rates are passed on immediately, why is the same not true with lower home loan interest rates? What are the Reserve Bank of India (RBI) and the National Housing Bank (the RBI subsidiary which regulates housing finance companies) doing about this? Aren’t the regulators also supposed to take care of the consumers? Or are they just there to bat for those who they regulate? Or is it a case of “regulatory capture” where those who are regulated (i.e. the banks and the housing finance companies) given that they are organised, manage to get their point of view to the regulator, but the borrowers, given that they are not organised, cannot do that.

Whatever it is, it is not fair. And the RBI and the National Housing Bank need to do something about it. Consumer protection is something that should be high on their agenda, even though it may be the most unglamorous of things that they are supposed to do.

The column originally appeared in Equitymaster on December 14, 2017.

Using Deposits to Rescue Banks is a Bad Idea; It Needs to Be Nipped in the Bud

Indian_ten_rupee_coin_(2008_Reverse)
I have been travelling for the past two weeks and a question that has been put to me, everywhere I have gone is: “will fixed deposits be used to rescue banks that are in trouble?

People have been getting WhatsApp forwards essentially saying that the Modi government is planning to use their bank deposits to rescue all the banks that are in trouble. As is usually the case with WhatsApp, this is not true. The truth is a lot more nuanced.

Let’s try and understand this in some detail.

Where did the idea of fixed deposits being used to rescue troubled banks come from?
The government had introduced The Financial Resolution and Deposit Insurance(FRDI) Bill, 2017, in August 2017. This Bill is currently being studied in detail by a Joint Committee of members belonging to the Lok Sabha as well as the Rajya Sabha.

The basic idea behind the FRDI Bill is essentially to set up a resolution corporation which will monitor the health of the financial firms like banks, insurance companies, mutual funds, etc., and in case of failure try and resolve them.

The Clause 52 of the FRDI Bill uses a term called “bail-in”. This clause essentially empowers the Resolution Corporation “in consultation with the appropriate regulator, if it is satisfied that it necessary to bail-in a specified service provider to absorb the losses incurred, or reasonably expected to be incurred, by the specified service provider.”

What does this mean in simple English? It basically means that financial firms or a bank on the verge of a failure can be rescued through a bail-in. Typically, the word bailout is used more often and refers to a situation where money is brought in from the outside to rescue a bank. In case of a bail-in, the rescue is carried out internally by restructuring the liabilities of the bank.

Given that banks pay an interest on their deposits, a deposit is a liability for any bank.
The Clause 52 of FRDI essentially allows the resolution corporation to cancel a liability owed by a specified service provider or to modify or change the form of a liability owed by a specified service provider.

What does this mean in simple English? Clause 52 allows the resolution corporation to cancel the repayment of various kinds of deposits. It also allows it to convert deposits into long term bonds or equity for that matter. Haircuts can also be imposed on firms to which the bank owes money. A haircut basically refers to a situation where the borrower negotiates a fresh deal and does not payback the entire amount that it owes to the creditor.

But there are conditions to this…
The bail-in will not impact any liability owed by a specified service provider to the depositors to the extent such deposits are covered by deposit insurance. This basically means that the bail-in will impact only the amount of deposits above the insured amount. As of now, in case of bank deposits, an amount of up to Rs 1 lakh is insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC). This amount hasn’t been revised since 1993.

Typically, anyone who has deposits in a bank tends to assume that they are 100 per cent guaranteed. But that is clearly not the case. Over the years, the government has prevented the depositors from taking a hit by merging any bank which is in trouble with another bigger bank.

So, to that extent the situation post FRDI Bill is passed, is not very different from the one that prevails currently. It’s just that the government has come to the rescue every time a bank is in trouble and I don’t see any reason for that to change, given the pressure on the government when such a situation arises and the risk of the amount of bad press it would generate, if any government allowed a bank to fail.

Over and above this, Clause 55 of the FRDI Bill essentially states that “no creditor of the specified service provider is left in a worse position as a result of application of any method of resolution, than such creditor would have been in the event of its liquidation.” This basically means that no depositors after the bail-in clause is implemented should get an amount of money which is lesser than what he would have got if the firm were to be liquidated and sold lock, stock and barrel.

While, this sounds very simple in theory, it will not be so straightforward to implement this clause.

So why is the government doing this?
In late 2008 and early 2009, governments and taxpayers all over the world bailed out a whole host of financial institutions which were deemed too big to fail. In the process, they ended up creating a huge moral hazard.

As Mohamed A El-Erian writes in The Only Game in Town“[It] is the inclination to take more risk because of the perceived backing of an effective and decisive insurance mechanism.”

If governments and taxpayers keep rescuing banks what is the signal they are sending out to bank managers and borrowers? That it is okay to lend money irresponsibly given that governments and taxpayers will inevitably come to their rescue.

In order to correct for this moral hazard, in November 2008, the G20, of which India is a member, expanded the Financial Stability Forum and created the Financial Stability Board. The Board came up with a proposal titled “Key Attributes of Effective Resolution Regimes for Financial Institutions”. This proposal suggests to “carry out bail-in within resolution as a means to achieve or help achieve continuity of essential functions”. India has endorsed this proposal. Hence, unlike what WhatsApp forwards have been claiming this proposal has been in the works for a while now.

But does this really prevent moral hazard?
A bulk of the banking sector in India is controlled by the government owned public sector banks. As of September 30, 2017, these banks had a bad loans rate of 12.6 per cent (for private banks it is at 4.3 per cent).  Bad loans are essentially loans in which the repayment from a borrower has been due for 90 days or more. The bad loans rate when it comes to lending to industry is even higher. In case of some banks it is close to 40 per cent.

This is primarily because banks over the years, under pressure from politicians and bureaucrats, lent a lot of money to crony capitalists, who either siphoned off this money or overborrowed and are now not in a position to repay. This is a risk that remains unless until the banking sector continues to primarily remain government owned in India.

Also, the rate of recovery of bad loans of banks in 2015-2016, stood at 10.3 per cent.  This does not inspire much confidence. In this scenario, having a clause which allows the resolution corporation to get depositors to pay for the losses that banks incur, is really not fair. The moral hazard does not really go away. The bankers, politicians and crony capitalists, can now look at bank deposits to rescue banks. As of now, the government and the taxpayers have kept rescuing public sector banks, by infusing more and more capital into them. Now the depositors can take over, if FRDI Bill becomes an Act.

It is worth pointing out here that the other G20 countries which have supported this proposal have some sort of a social security system in place, which India lacks. Given this, deposits are the major form of savings and earnings for India’s senior citizens and clearly, they don’t deserve to be a part of any such risk.

While, any government will think twice before using depositor money to rescue a bank, this is not an option that should be made available to governments or bureaucrats in India. It is a bad idea. It needs to be nipped in the bud.

These are my initial thoughts on the issue. Depending on how the situation evolves, I will continue to write on it.

The column originally appeared on Equitymaster on December 11, 2017.