Bank lending and deposit rates to continue to move higher

Contrary to widespread expectations of a rate hike, the RBI surprised markets (though not pleasantly) by holding its key policy repo rate -- at which banks borrow short-term funds from the RBI. Even so, borrowers should not rejoice prematurely. Lending rates are set to move higher -- rate hike or no -- as banks will continue to take cues from the bond market. Risks to fiscal slippages, global factors and the depreciating rupee are likely to lead to hardening of yields in the coming months.

Banks have already been raising lending and deposit rates notably over the past six months. The RBI reversing its neutral stance to one of calibrated tightening of monetary policy (slightly softer than a hawkish stance), does not rule out rate hikes in the remaining part of FY19. While the RBI has lowered its inflation projection for the second half of the fiscal, banking on benign inflation, there are multiple upside risks to the RBI’s inflation projection. We expect two rate hikes by the central bank by March 2019.

On the rise

Even as the RBI has held its key rate, banks are likely to continue raising lending and deposit rates. Remember, even after the RBI’s last rate cut in August last year, the yield on 10-year government bonds have only moved up. Taking cues from the bond market, banks have been raising deposit and lending rates since January this year, even though the RBI started to hike its rate only in June this year.

While deposit rates have gone up by 25-50 basis points on an average, a few banks have raised interest rates on specific tenure deposits by as high as 90-100 bps since January.

Since deposit rate increases immediately reflect on banks’ cost of funds under MCLR, hikes in lending rates have also been much quicker and sharper. Banks’ benchmark lending rate — one-year MCLR — has gone up by 25-35 bps on an average, to as high as 60-70 bps in a few banks over the past six months.

But despite such a sharp increase, bank lending rates are set to move higher on account of several factors. One, the recent liquidity crisis after the IL&FS episode will keep market rates on the longer tenure bonds high and sticky. Banks taking cues from the bond market, will likely raise lending rates in the coming months. Two, upside risks to RBI’s inflation projection still leaves the possibility open for more rate hikes. Three, given that the risk perception in the system has turned adverse after recent events, banks will price some of this into lending rates — in particular for lower rated corporates.

For retail borrowers waiting on the fence, this may be the right time to shop for the best rates in the market. For existing borrowers, reset clauses under the MCLR structure will cushion the impact to some extent. Remember, under MCLR-based pricing, lending rates are reset only at intervals corresponding to the tenure of the MCLR. Hence, in the case of home loans, which are benchmarked against the one-year MCLR, lending rates will only be reset every year.

However, those who took loans last year, reset in lending rates are likely to pinch them, as MCLR has moved up by 30-40 bps in the past one year.

What for banks

Going by the June quarter results, increase in deposits rates that in turn bump up banks’ cost of funds, have added some pressure on banks’ margins. But for a few banks that have hiked benchmark lending rates by 20-25 bps since August, there could be some easing of pressure in the September quarter. That said, asset quality performance remains a critical factor. Sharp slippages and provisioning will continue to weigh on earnings. The rise in lending rates could only accentuate the bad loan issue. The actual impact of the IL&FS crisis on the banking sector is also yet to be seen.

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