SBI, HDFC Bank slash deposit rates: Rate cut lobby needs to let Rajan do his job

Most banks have begun reducing their deposit rates in the last two months. The trend began in October, when a clutch of state-run banks, including the country’s largest lender State Bank of India (SBI) slashed their deposit rates by up to 100 basis points (bps). One bps is one hundredth of a percentage point.

This was followed by more banks, both in public and private sector, including ICICI Bank, Bank of India, Andhra Bank, Axis, HDFC, IDBI and Kotak Mahindra, which too brought down their deposit rates.

On Friday, SBI again cut its deposit rates by 25 bps saying high liquidity in the banking system warranted such an action. The bank lowered the interest rate on term deposits for 1-3 years and 3-5 years to 8.5 percent from existing 8.75 percent, while for deposits with maturity 5 years and above, the rate was reduced to 8.25 percent from current 8.50 percent.

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Most likely, the current spree of deposit rate cuts will be followed by cut in lending rates by banks-much-awaited by individuals and industries and the primary reason why people seek a rate cut from the Reserve Bank of India (RBI)-sooner or later. The likelihood of this happening in the next few weeks cannot be ruled out.

The interesting fact is that cut in loan rates can happen even before Raghuram Rajan begins to cut his key policy rate, signaling downward interest rate regime.

Technically, a repo rate cut is more of a policy signaling tool than a liquidity tool. It signals banks what to do with their interest rate structure. Repo is the rate at which the RBI lends short-term funds to banks. On the other hand, cash reserve ratio (CRR) is a liquidity tool. A cut in CRR released sizeable chunk of funds to the banking system at once.

But in recent years, the process of monetary policy transmission or banks taking signals from the central bank and acting accordingly has been limited.

This is due to a combination of factors including slow credit growth in the absence of loan demand in an economy that has experienced prolonged slowdown in two continuous fiscal years. Even though the RBI has hiked its key rate by a total 75 bps since Rajan took over, banks have hardly increased their rate in the same fashion.

Also, technically, effective monetary policy transmission can happen if the banking system remains in a liquidity deficit mode, which isn’t the case now.

Following the Urjit Patel committee proposals, the RBI has significantly shifted its focus to term repo market from overnight lending and has conducted plenty of open market operations (OMOs-sale or purchase of Government bonds from banks) in the recent past, enabling the baking system in a comfortable liquidity mode. Hence banks didn’t go for any meaningful hikes in their loan rates.

Applying the same rules, banks are unlikely to go for reduction in their lending rates even now strictly due to the policy signals from the RBI. But they will certainly do so for their own reasons. These are:

For one, as mentioned earlier, loan growth has consistently lagged behind the deposit growth resulting in an imbalance in the asset-liability structure of banks. Higher accumulation of deposits with not much avenues to deploy funds (read loan demand) results in a higher carry cost of the money in hand for banks.

Significant cut in deposit rates will have to be, thus, followed by cut in loan rates as otherwise banks will struggle to deploy the excess funds. The reason for the rampant deposit rate cuts by banks in recent months is to discourage fresh inflow of money by disincentivising the depositors than due to the interest rate signal as often interpreted.

Besides, banks also take into account the deposit rates while calculating their base rate or minimum lending rate on a quarterly basis. In a falling deposit rate scenario, the base rate will have to naturally come down.

Two, with no revival in loan demand in sight, banks will be left with no option but to start cutting loan rates. The main reason for slowdown in the loan growth is absence of demand from corporations.

In the case of large firms, not many fresh projects have come up in the last two years nor have the projects stalled for various reasons been brought back on track. In the case of mid-sized firms, the reason why banks aren’t lending is the high amount of bad loans.

Most of the SMEs suffered a big jolt when business cycle took a major hit in the aftermath of the 2008 financial meltdown and the subsequent shrinkage in exports. With their cash flows under stress, loan repayments to banks stopped, in turn, forcing banks to shut funding channels for these companies.

If one looks at the RBI data, it is quite clear that in the last two years, very little money has gone to mid-sized firms. The even smaller companies or micro-firms got lucky because under the priority sector lending obligation, banks must fund them to fill the annual quota.

The situation, however, is expected to change in the ensuing months since there are early signs of revival in the economy, which could translate to pick up in business, requiring bank funding. In this scenario, banks will be left with no option but to start cutting lending rates when competition kicks in.

Three, short-term rates and the 10-year government bond have eased significantly in this fiscal year so far. The rate on one-year commercial paper rates, which corporates issue to raise funds, have fallen below 9 percent compared to about 9.55 percent in April, while a similar decline in seen in the certificate of deposit rates as well, where the rate now is 8.62 percent compared with 9.15 percent in April.

If banks do not lower lending rates, most companies, especially the top-rated one will turn to the bond market to meet their funding needs.

On the other hand, even a quarter percentage point repo rate cut by RBI may not be enough to prod banks to effect significant reduction in their lending rates.

The chorus for a rate cut, for this reason, doesn’t make much sense.

The RBI has created sufficient liquidity in financial system and has kept its single-minded focus on fighting down inflation by keeping the signaling rates high.

The apex bank has repeated that it wants bring down the actual inflation numbers in a sustainable manner and thus contain the high inflationary expectations among the general public, before reversing its policy stance sometime next year.

For the sake of the economy, it is the best to leave Rajan alone to finish his job. Whether banks cut lending rates or not is not in his hands.