Due Diligence. The small savings blow to lending

The RBI has cut the repo rates by 125 basis points (bps) since the beginning of 2015, but most banks have cut their lending rates by only 50-75 bps.

Given this, banks are under pressure from the RBI to pass on the full benefit of the repo rate cuts to their borrowers. However, multiple compulsions are usually cited for not doing so.

One commonly cited reason is the high interest rates offered by the government on small savings schemes.

These high rates purportedly make it difficult for banks to cut their deposit rates and consequently lending rates.

Banks claim that if small savings schemes continue to offer higher interest rates, bank deposits would become less competitive and hence unattractive for retail investors.

According to a recent news report, a review has been launched by the Finance Ministry to explore the option of linking small saving schemes’ rates to the repo or to banks’ deposit rates in order to reflect the reality of moderating inflation.

So, will that make banks bring down their lending rates more promptly than they do now? Let’s take a close look.

Factors at play Banks consider multiple factors when deciding their lending rates. The most important is their cost of funds — the overall rate at which they borrow funds. As deposits make up the largest cost component for banks, depending on the nature of the deposits — demand and time deposits — the cost of funds vary. For a bank with high current account and savings account (CASA) deposits, the overall cost of funds would be low, as the bank pays no interest on money kept in current accounts and 4-6 per cent on savings accounts. So, the cost for a bank with 40 per cent CASA deposits would be lower than that for one with 25 per cent CASA deposits.

Asset quality also plays a crucial role in deciding the overall cost. A bank with high non-performing assets may see its net interest margin (NIM) falling. This may force it to cut deposit rates and keep lending rates high to maintain a certain level of NIM.

The effect At present, small savings’ rates are linked to yields on government bonds of similar maturity. The rates are revised annually by calculating the average previous yield on government bonds.

The government pays a premium of 25-50 basis points over and above the average G-Sec yield.

In a falling interest rate regime, this cushion would disappear for existing account-holders of small savings schemes if their rates were to be linked to bank deposit rates or repo rate.

This is because the annual interest on small savings schemes would keep getting revised downwards every year even for older investors, unlike long-term bank deposits where rates would continue to be higher.

The Government may prefer to shield investors in small savings from a volatile slide in interest rates by continuing to link them to G-Sec yields rather than the repo rate or bank deposit rates. The latter can see multiple revisions in a single year as has happened currently.

What can borrowers expect Finally, the small savings rate is just one of the metrics banks would consider to set lending rates. Even if deposit rates of small savings schemes were linked to the repo rate, unless banks’ asset quality improves, they may not be able to fully match every repo rate cut with a corresponding lending rate cut.

In such cases, even the RBI would be hard-pressed to urge banks to pass on the full benefit of policy rate changes to borrowers. Beyond a point, it may be prudent to let market forces drive bank lending rates.

As for borrowers, they always have the option of switching their loans to banks charging lower interest rates.

The writer is CEO, Bankbazaar.com

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