Media headlines are screaming on the government directive to banks to reduce loan rates. The fact the RBI cut the repo rate by 50bps in its annual policy for 2012-13 is seen as a signal for banks to lower lending rates. If media headlines hold true, the government is forcing banks to pass on the rate cuts to the borrower in order to spur consumption and investment in the economy. The government in its misguided belief is trying to pass through monetary policy into the system so that rate cuts take effect immediately.
The government is doing a great disservice by telling banks to lower lending rates. It is actually harmful to the economy if banks act on the wishes of the government. The reason is, if banks do lower lending rates, against solid business reasons, it will only alienate the needy. Banks in order to please the government will lower rates for borrowers who actually do not require funds. To compensate for lower rates for prime borrowers, banks will hike rates for borrowers who are lower down in the credit rating scale. Hence for example a cash rich company like Reliance will find loans cheaper while a mid size company that is finding its margins squeezed will find loans more expensive.
In times when liquidity is poor with banks borrowing around Rs 100,000 crores from the RBI on a daily basis, the cost of liquidity becomes extremely important in determining lending rates. Banks are struggling to absorb a heavy government borrowing with weekly bond and treasury bill auctions at around Rs 30,000 crores. Apart from government bond auctions, there are state loans and corporate bond issuances, in which banks have to participate. Banks have to strike a right balance between providing credit to the economy and absorbing high supply of paper.
In such times of strained liquidity, government interference in lending rates of banks will harm banks and harm the banks customers as well. Banks will find their margins getting squeezed and will then lower deposit rates to keep margins on an even keel. Banks will also force lower rated borrowers out of the market, as there will be no appetite for credit risk when the government determines the pricing of the credit.
To top it all banks are facing restructuring of loan issues with loans of government owned companies such as Air India being restructured. The restructuring of around Rs 30,000 crores of loans was forced on the banks and there is no way of knowing whether it is good money thrown after bad. Banks in such cases should have representations on the board of the company and participate actively in the running of Air India as their money is involved.
Loans of Power Companies, Private Airlines, Private Hotels, State Electricity Boards, Real Estate Companies are all coming up for restructuring leading to a hugely reduced appetite for credit risk by banks. Banks neither have the liquidity nor have the will to lend to lower rated borrowers until they can get back on track on NPA (Non Performing Assets) containment.
Allow the banks to function normally for loan rates to come off
RBI has signaled to banks to banks that it will take care of their liquidity needs. RBI has allowed banks to go below 2% of SLR (Statutory Liquidity Ratio) to access standby funds (called MSF or marginal standing facility) in case of desperate need. Banks are already running excess SLR of 5% giving them a liquidity cushion of around Rs 300,000 crores.
The natural path for banks to take given rate cuts and given access to liquidity is to reduce deposit rates first. Lower deposit rates will translate to steady to higher profits for banks, as lending rates will remain sticky for a while. Once loans come up for re pricing, banks will lower loan rates if demand for loans at higher levels is low. Given the current investment environment when companies are stalling any new projects (drop in sanctioned projects is over 60% last year), demand scenario for loans is not healthy. Banks will then be forced to reduce loan rates to increase credit growth.
The whole process of re pricing of loans will take at least six months. However with government interference, the process will get delayed and this delay in loan re pricing will harm the economy.