The RBI recently fine-tuned the marginal cost of funds based lending rate (MCLR) guidelines, originally issued in December 2015, hoping it will quicken monetary policy transmission, a contentious issue today in the context of reduction in lending rates.

The RBI’s case has been that banks, barring a few, have not reduced lending rates enough, in spite of reduced marginal cost of funds on account of the rate cuts by the apex bank.

But banks have been arguing that they need to price loans based on average rather than marginal cost of funds.

This would appear to be an academic debate and there are at least two aspects that lend credence to this view.

First, unless banks have a large stockpile of lower-cost, long-dated liabilities (which is not the case), the difference between average and marginal costs is unlikely to be significant. This is because the weighted average maturity of liabilities (deposits and borrowings) is only about 1.7 years.

Also, since CASA deposits account for over 35 per cent of total deposits, a large segment of the borrowing cost is insulated from the RBI base rate changes. The impact on transmission from RBI rate changes may, therefore, not be significant.

While it could be argued that even a small basis point reduction in lending rates would help, we need to appreciate that costing is only one of the factors that influence banks’ loan pricing decisions.

Rate cuts hurt income The reluctance of banks to pass on base rate cuts to borrowers has more to do with the revenue side of their balance sheets. First, consider the composition of their loan portfolio — nearly 30 per cent of the outstanding advances is in the form of cash credit (overdrafts), a category where interest rate changes take immediate effect on the entire outstanding, unlike term loans. Secondly, given the short weighted average maturity of loans (2.8 years), it’s likely that a larger chunk of banks’ interest income during a year accrues from fresh disbursals of credit than from existing outstanding. While this explains the income side of the issue, the key reason is probably the risk premium component of lending rates.

Risk premium The RBI Governor has been referring to this aspect in the past when faced with criticism that the RBI was not reducing rates fast enough, stating that the RBI could at best influence only the base rate; lending rates were high because of the risk premium (read the cost of bad debts). The risk premium is a cost of doing business that flows from the massive NPA stockpile and plays out in three ways — by reducing current income (since banks cannot recognise interest on NPAs), by loan loss provisioning and finally, the cost of additional borrowings needed to make good the loss of cash flows from loans.

The first two relate to the income effect, and the last to the liquidity impact of NPAs. The liquidity crunch that banks are complaining of late is not just due to deposits slowing down but is the impact of blocked cash flows in loans. We know that it is liquidity (the orderly flow back of assets) rather than profitability that is the life blood of financial intermediaries.

The haunting past The impact of NPAs on bank profits is unfolding with every release of banks’ results. In the current context, therefore, the key to any significant drop in lending rates would depend on how the NPA problem pans out.

Although the official gross NPA ratio was around 4.45 per cent in March 2015, the stressed assets (NPAs and restructured loans) ratio of public sector banks rose by an alarming 131 bps to 13.2 per cent (over ₹7,12,000 crore) in FY15. The fact that loans are still getting restructured rather than closed out indicates that the problem may not have peaked yet.

It remains to be seen how much of an effect costing methodology would have on lending rates, especially to wholesale corporate credit.

The writer is an independent consultant

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