Here's how borrowers lose when govt orders banks to cut lending rates

A media story suggesting that the government has issued a directive to state-run banks to reduce lending rates has got several commentators bothered.

The fact that the RBI cut the repo rate by 50 basis points 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 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 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.

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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-sized company that is facing squeezing margins will find loans more expensive.

In times when liquidity is poor - banks are borrowing around Rs 1,00,000 crore from the RBI on a daily basis - the cost of liquidity becomes extremely important in determining lending rates. Banks are struggling to absorb heavy government borrowings with weekly bond and treasury bill auctions at around Rs 30,000 crore.

[caption id=“attachment_282762” align=“alignleft” width=“380” caption=“Banks are struggling to absorb heavy government borrowings with weekly bond and treasury bill auctions at around Rs 30,000 crore.”]  [/caption]

Apart from government bond auctions, there are state loans and corporate bond issuances, in which banks have to participate. Banks have to strike the 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 bank 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 credit.

To top it all, banks are facing several instances of debt restructuring. For instance, loans of loans of government owned companies such as Air India being restructured. A restructuring of around Rs 30,000 crore in loans was forced on banks and there is no way of knowing whether that is good money thrown after bad right now. 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.

In addition, loans of power companies, private airlines, private hotels, state electricity boards, real estate companies are coming up for restructuring, which will lead to a hugely reduced appetite for credit risk by banks. Banks neither have the liquidity nor the inclination to lend to lower-rated borrowers until they can get back on track on NPA (non-performing assets) containment.

Allow banks to function normally for loan rates to fall

The RBI has signaled to banks that it will take care of their liquidity needs. It has allowed banks to go below 2 percent 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 percent, giving them a liquidity cushion of around Rs 3,00,000 crore.

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 (the drop in sanctioned projects is over 60 percent last year), the 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 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.

Arjun Parthasarathy is the editor of www.investorsareidiots.com, a web site for investors.