Policy rate transmission to deposit rates - should it be mandatory?

Deposit rate revision needs more transparency

Repo rate hiked: Monetary Policy Committee (MPC) increased the policy repo rate from 4.0% to  4.90% since May 2022. (increase of 40 bps in May 2022 and 50 bps in June 2022). (In fact, RBI Deputy Governor and MPC member, Dr. Michael Debabrata Patra says MPC has effectively tightened the  market by130 bps, if one takes into account the increase of 40 bps paid to banks, when they place their surplus funds with RBI under reverse repo (now christened Standing Deposit facility - SDF)).

Increased Earnings for banks: With the revision in repo rates, majority of the public and private sector banks have revised their EBLR (external benchmark linked lending rate) linked to repo rates by 90 bps. MCLR, an internal bench mark rate linked to marginal cost of funds, have also been revised by almost all the banks, though the upward revision varies from 30 to 50 bps among individual banks.  Considering the fact that EBLR loans account for 44% of total floating rate loans, which are reset at quarterly intervals, and the rate is offered in loan segments where growth is happening, (all retail and MSME loans are linked to EBLR), the banks stand to gain in earnings, from existing as well as new loans covered under EBLR. Even in respect of loans linked to rates like MCLR, Base Rate, etc., the increase in interest income is likely to be significant,  as the upward revision, though slightly lower than EBLR, is across the board on all the loans.

Whether the same trend is reflected in deposit interest rates? I am interested as a senior citizen, who depends on pension (I am in the fortunate eligible minority category in India drawing pension!) and interest from his superannuation benefits placed as bank deposits. Except one or two banks, which went for a hike of 40-50 bps in select buckets, the increase from the other banks is confined to 20-30 bps only. Even small finance banks (SFBs), some of which were offering 6% plus on their deposits much earlier, so as to replace high cost borrowings with bank deposits and also manage  their liquidity mismatches, have not made a matching increase in deposit rates as compared to the revision in loan rates. Only one bank revised its savings interest rate by 50 bps for those holding balances in excess of Rs.50 lacs, leaving the rates for small savers unchanged. A major PSB revised its bulk deposit rates by 50-60 bps; however the increase in retail deposit rates was restricted to 15-20 bps only. 

Is the lesser increase in deposit rates when compared with the hike in loan rates justified? There may be some arguments to justify the less increase like the following: 

• CRR has been hiked by 50 bps
• Fixed rate loans, where no revision in rate is effected, account for 24% of the gross advances in the banking system
• Interest revision in respect of loans linked to MCLR, Base Rate, etc. gets implemented after a time lag viz. on the date of reset as per agreement

My submissions are 

1. The negative carry due to increase in CRR works out to just 4.4 bps. (Ann. 2)
2. Of the fixed rate loans, agriculture loans account for 12.6% of total advances. The rest are either loans against deposits (2 to 2.5% more than the relevant deposit rates) or fixed rate loans, which carry a minimum of 1.5 to 2% over the floating rate loans in that category. So agri. loans may be the category, where  the banks may not get the benefit of upward revision in lending rates. But one should remember that agri. loans carry an interest rate of nine plus percent including the interest subsidies paid by the state/central governments, which is quite high over the average yield in gross advances.
3. Most of the MCLR/Base Rate linked loans have a reset clause of 3 months and less. So the time lag to attain the gain in earnings is really short.

On the other hand, any increase in fixed deposits need not be passed on to the loan customers in full, since the average CASA  account for 35-40% of the total deposits in a majority of the banks. In fact, CASA acts as a buffer to reduce the overall impact caused by increase in fixed deposit interest rates. In this scenario, I cannot be faulted, if I make a statement that the increase in fixed deposit rates should at least be equivalent to the increase effected in lending rates, with other factors remaining constant like there is no change in SB rates, operating costs, etc.

With the above inputs, I calculated how much the cost of funds will go up for a bank, if it increases its fixed deposit rates by 60 bps across all tenors. (Ann. 2), as cost of funds form the base for increasing lending rates. When there is no appreciable increase in stressed assets, the cost for a bank goes up by 30 bps and the  internal/external benchmark rates needs to be increased only by that measure.  However in an increased stressed assets scenario, the cost of funds will witness an increase in operating cost and a bank may have to increase their internal/external benchmark rates by 48 bps. In both the situations, the increase in external/internal benchmark rates should be much lower than the increase in fixed deposits. (half of the increase in fixed deposit rates in a normal scenario and four fifth of the increase in a scenario of enhanced stressed assets). To put the argument in another way, a bank should increase its fixed deposit rate that is at least equivalent to the average increase in floating loan rates (instead of average increase in yield on advances) as CASA forms substantial portion of its total deposits. 

There should exist a correlation between the average  revision in floating loan rates and revision in fixed deposits, in a scenario, where the savings rate get revised only marginally. In a scenario where savings rates are also revised like fixed deposit rates, the correlation should be between the average revision in floating lending rates and the revision in cost of deposits. Otherwise, the upward revision in policy rate may only help bankers to increase their Net Interest Margin!

Finally, when the policy rate was on a downward path, RBI and the government used all the powers at their command, by making it mandatory for the banks to link major loan segment interest rates with external benchmark rates.  To ensure that the borrowers get the benefit of any downward revision in policy rate immediately, even the reset was decided as three months by RBI. (It is another matter that the above instructions are now used by the bankers to their advantage, at the expense of borrowers). In the same way, when the policy rate is on an upward curve, RBI should intervene to ensure transmission of policy rates to depositors, since the banks will increase their lending rates any way.

Incidentally, when the interest rates for depositors was reduced keeping the unreal repo rate as the benchmark, even the small savings schemes, a window available for retail investors, were also not spared. The small savings schemes' interest rates were brought down by linking them to corresponding yield in g-sec. And RBI savings bonds for a period of 7 years is in operation with interest rate ruling at 35 bps above NSC certificates issued by post offices. Since then, the 10 year g-sec has travelled upwards from 6.4% to 7.6% now and so are the other g-sec. for different tenors upto 10 years. However, neither small savings went for a revision nor the RBI savings bond linked to NSC has increased. The statements issued by the government and RBI  that the same rate will continue for another three months from 1st July 2022 disappointed retail investors, especially senior citizens.

Bank depositors are after all the major investors to the Indian economy as their deposits are invested by banks, the intermediaries, into loans to borrowers, bonds and govt. securities (the government borrows to meet revenue and capital expenditure, both of which gets invested in the economy).  Since upward revision in policy rate is a reflection on the prevalent inflation, the suppliers of money (both bankers and depositors) should get compensated adequately. Will RBI mandate the bankers that there should be a correlation between loan lending rates and fixed deposit rates and any increase in rates on one side should get adequately reflected in the other side also.

Regards

V. Viswanathan 

15th July 2022

Annexure I

RBI Master Directions on Interest Rate on Advances

Scheduled commercial banks charge interest on advances based on master directions issued by RBI.  1.     FIXED RATE LOANS: Advances/loans against bank’s own fixed deposits and agricultural advances are offered at fixed rates by the banks. 2.    FLOATING RATE ADVANCES: All other advances are generally extended at floating rates, by linking it to a reference rate, which is reviewed at periodic intervals, based on change in policy rates, revision in cost of funds due to change in any internal or external factor in mobilising funds. The reference rate, known as benchmark rate, may be internal or external Ø    Internal Bench Mark Rate: All floating rate loans sanctioned between 1st July 2010 and 31st March 2016 shall be priced with reference to the internal bench mark rate called the base rate. All floating rate loans sanctioned/renewed with effect from 01st April 2016 are referenced to the new internal benchmark rate known as marginal cost of funds based lending rate (MCLR).The components for arriving at MCLR are as under: a.       Marginal cost of funds; b.      Negative carry on account of CRR; c.       Operating costs; d.      Tenor premium (Base rate also had the same components as above except that it uses average cost of funds in place of marginal cost of funds) Ø    External Benchmark Rate: All new floating rate personal or retail loans (housing, auto, etc.) and floating rate loans extended by banks to Micro and Small Enterprises from October 01, 2019 and floating rate loans to Medium Enterprises from April 01, 2020 are benchmarked to one of the following:  Ø  Reserve Bank of India policy repo rate Ø  Government of India 3-Months Treasury Bill/ 6-Months Treasury Bill yield published by the FBIL Ø  Any other benchmark market interest rate published by the FBIL. Banks are free to decide the spread over the external benchmark. However, credit risk premium may undergo change only when borrower’s credit assessment undergoes a substantial change and other components of spread including operating cost could be altered only once in three years. The interest rate shall be reset at least once in three months.

 Annexure II

Increase in marginal cost of funds*

Assumptions: CRR increased from 4.0% to 4.5% Deposits Rs.100; NDTL(net Demand & Time Liabilities): Rs 110. Average CASA 35%; CA 10%; SB 25%  Fixed deposit rates up by by 60 bps across all tenors; Interest rate on domestic SB accounts up by 50 bps for balances above Rs.50 lacs 90 % fixed deposits get renewed on due dates. Maximum fixed deposits are in the time buckets of 1 and 2 years.  Growth in deposits projected at 10% with CASA remaining at 35% New fixed deposits mobilised during the year Rs.13 (Fixed deposits at the end of the year Rs.65x110%(= Rs.71.5) minus deposits at end of previous year renewed at 90% (= Rs.58.5) = Rs.13.0 Yield on advances 8%;       Return on Net worth 12% In the above scenario, projected increase in cost of funds is calculated using the following MCLR Components: a.    Cost of Borrowings; b.    Negative Carry on CRR; c.    Operation Cost d.    Tenor Premium  a.      Cost of Borrowings: Fixed Deposits: New deposits Rs.13.0 attract fresh rates immediately. Old deposits renewed (at 90%)Rs.58.5 gets 60 bps increase with a time lag of 6 months (average term deposit period taken as 1 year) Increase in cost due to new deposits = 13.0x0.6%=7.8 bps  Increase in cost due to old deposits renewal at 90%= 58.5x0.6%/2=17.55 bps  Increase in Term Deposit Cost = Cost of new deposit + Cost of renewed deposits = 7.8+17.55=25.35 bps Increase in cost of Savings accounts:  Assuming savings deposits with outstanding balances above Rs.50 lacs as 10% of total savings deposits, the increase in cost works out to 25x10%x0.5% = 1.25 bps Increase in cost of deposits :Increase in fixed deposit + Increase in SB cost = 25.35+1.25=26.60 bps  Return on Net worth is taken at 12%  Increase in marginal cost of funds = 92% x  marginal cost of borrowings + 8% x Return on net worth = 92% x 26.60 + 8% x 12 = 24.48 + 0.96 =  25.44 bps say 25.5 bps b.      Negative Carry on CRR: Increase in CRR requirements: NDTL:110×0.5%=Rs.0.55 to be additionally parked with RBI.  Negative Carry - Opportunity earnings lost = Additional amount maintained with RBI x average yield on advances =  0.55×8%= 4.4 bps c.       I have assumed operating costs as negligible and no change in tenor premium since no perceptible change is visible in both due to increase in fixed deposit rates alone. Increase in Marginal Cost : Increase in cost of borrowings + Negative carry on CRR = 25.5 + 4.4 = 29.9 bps say 30 bps The banks are flush with liquidity. Hence I have not added any cost on borrowings. But there are a few banks, which may have to borrow for liquidity mismatches.  Assuming that the borrowings/bulk deposits account for 10% of the total liabilities and an increase in cost was up by 50 bps, the increase in marginal cost will go up by another 5 bps

  Increase in cost due to stressed loan assets

Assumption in CD Ratio at 75% 1% increase in GNPA means 0.75% of total advances will become non-earning assets. Interest income lost will be equivalent to 6 bps (0.75×8%= 6 bps). In addition the bank has to make a minimum 15% provision on the new GNPAs. Credit cost works out to 0.75% ×15= 11.25  bps  Increase in cost on account of stressed assets = Income lost + Provision made                        11.25+6= 17.25 bps.

 Increase in marginal cost with increase in stressed assets at 1% of gross advances:

Increase in Marginal Cost+ Income lost on fresh NPAs+Provision cost:               

30+17.25 = 47.25 bps say 48 bps.

 *(I have made the above calculations as a layman, which might not conform to the tenets on which the banks might be calculating their cost of funds. But I have included the components devised by RBI for arriving at the cost of funds.)