These days there is a widespread speculation about banks not lowering home / auto / any other loan’s rate of interest. This process is often tedious or involves a bit of cost at the end of borrower. There are also rumors floating around the fact that bank employees purposely burying its borrowers in a lot of paper work or just not reverting to such applications. The merit of these rumors can be discussed over a cup of coffee, but it’s immaterial when we are wondering why loans aren’t getting cheaper despite our Central Bank ie. Reserve Bank of India (RBI) has lowered the lending rates.
Before jumping right into the numbers, let’s look into how RBI decides whether the interest on our loans get cheaper or expensive.
Please Note: This will get a bit technical for the next couple of paragraphs. In case you don’t want to read it, feel free to jump ahead.
A country’s central bank has two important jobs. First is to control inflation, which means you don’t end up paying a hell of lot more money for the same stuff every year. If your mobile phone gets expensive every year, it’s not the job of a central bank to worry about. But if your expenses on very base essentials to get through the day gets expensive every year, then central bank definitely worries about it. That’s what they call as inflationary pressure.
Second and a very important job of a central bank is to look after the flow of money in a country. It goes like this, when the inflation discussed above rises up – it means things are getting expensive. In simple words, times are tough! A central bank then responds by making our loans a bit expensive so that we don’t spend it unnecessarily. On the contrary, when inflation comes down then a central bank is more than happy to lower the interest rates on loan. It means, times are good, things aren’t getting expensive so there in an incentive to go out and spend money or buy assets (physical or financial).
In a nutshell, when times are tough – RBI will make our loans expensive. And when times are good, RBI will make sure we spend money by making our loans cheap.
So how does RBI do this?
RBI does this with the help of Repo Rate. It’s basically the rate at which a country’s central bank lends money to commercial banks. As a result, commercial banks usually add their service charges and fees to it with some profit margin to the retail borrowers. In short, RBI’s one decision of a change in repo rate can have an impact on the rate of interest of our loans.
Here’s a look at repo rate’s journey of the last 20 years.
The first look at the last 20 years tells us that repo rates are at its lowest, which means our loans are cheapest that they have been in the last 2 decades. But will it always be like that in the future? It’s anybody’s guess.
Yet, a closer look at this chart gives an insight into the flexibility of repo rates. After 2008’s Lehmann crash, cheap money was infused in the system which was quickly reversed in less than 2 years. Enough has been written about those days. But since then, there has been a cautious approach to lowering the rates. And our hope is that it will stay low, if only Mr. Inflation doesn’t decide to spoil the party.
Allow me briefly introduce you to Mr. Inflation. He is often a late entrant to an ongoing party, just when things are going smooth, it’s his job to disrupt the party by simply putting a hand into your pocket. He comes in various forms, sometimes your milk gets expensive, then does the bread, petrol and diesel reaches beyond your wildest imaginations!
Suppose you want to go for a road trip in next 6 months. And the rational side of you likes to calculate an average cost. So you start saving some money from your salary. You calculated your petrol cost to be Rs. 10,000 based on Rs. 80 per liter. But then Mr. Inflation doesn’t like it. After 6 months when you are finally ready, he convinces our petroleum minister that his worth is not Rs. 80 per liter anymore. It’s worth 10% extra – Rs. 88 per liter. And so the price rises. And an extra Rs. 1,000 gets added to your wallet by you simply not doing anything.
Same is the case with our banking system. Mr. Inflation has a habit of troubling them a lot. Let’s not look too far back for it, just some 6 years odd will help us gain some perspective.
In 2016, after getting tired RBI decided to teach Mr. Inflation a lesson. There was a plan to keep it stable at 4% (+/- 2%). Monetary Policy Committee (MPC) was put in place to overlook the activities of Mr. Inflation and accordingly adjust the circulation of money in the system.
The plan seems to have worked as 8 to 9% of Consumer Price Index (CPI) – which tracks basic essentials of Indians was brought down to near 2% in mid-July 2017. After that Mr. Inflation did decide to fight back and come to 5% but never crossed the Lakshman Rekha of 6%. But then COVID-19 also had some part to play. 2020 has been a year when CPI has really shot up, currently it’s around 7% which is hurting our wallets even more.
One might argue that their expenses have gone up significantly and not just by 2% or 5% odd. That’s another face of Mr. Inflation which we fondly called as lifestyle inflation. But that’s for another day.
In an ideal scenario, RBI would love to keep low interest rates with low inflation. A higher inflation often makes the projects unviable. Suppose, you have taken a business loan from a bank. In your cost sheet, you have assumed labor cost at a specific % of the product. But then somehow, in the middle of the project your labor cost shoots up by 20-30% odd for some reason and suddenly your profit margins are hit and paying back the amount of loan to bank becomes tough. Sometimes its regulatory approvals that delays a project or at times it can be a raw material cost increase that cannot be passed on to the client, etc.. There are many ways where a business simply becomes unviable.
And when banks cannot get back the money they have lent, it becomes tough for them to survive. This results in good amounts of bad loans or Non-Performing Assets (NPAs) that affects the long term survival of the bank.
RBI in its recent working paper, ‘Banking Capital and Monetary Policy Transmission in India’ illustrated this point as, “The degree and speed of monetary policy transmission have been debated over the years in India. Banks often face many structural and frictional issues which dampen the transmission of monetary policy. The impediments to transmission are many, but the scourge of high non-performing assets (NPAs) of banks has played a major role in blocking the transmission. In an environment of sustained asset quality stress impacting the capacity of banks to lend, the government has infused capital in public sector banks to improve their capital position and facilitate credit extension. The RBI has also deferred the implementation of the last tranche of Capital Conservation Buffer (CCB) up to April 1, 2021 to provide some respite to banks facing difficulty in raising additional capital in a situation of already high provisioning requirements due to asset quality corrosion. Though these measures have helped some public sector banks to come out of regulator’s critical purview, the bank credit grew by only 13.4 per cent in 2018-19 and 6.1 per cent in 2019-20. “
Banking sector credit shows us how much money has been lent by banks. In the Economic Survey of 2019-20, it was compared with India’s GDP. The above chart shows the expansion in the supply of credit or loans with the entry of private banks. It has somehow been a bit shaky in the past few years but the trend seems to be upward facing. It cannot be denied that private banks have changed the game. Better services offered, quick turnaround time and most of all much better experience when a customer walks into the bank.
At the same time, private banks have done a very good job in terms of managing their risks in terms of loans offered. It has enabled them be flexible and lower their interest rates in comparison to its public sector peers.
To understand this further, let’s do a bit health check-up of Indian banks. There is an extremely simple parameter called capital adequacy ratio (CAR) or capital to risk weighted asset ratio (CRAR). The CRAR is the capital needed for a bank measured in terms of the assets (mostly loans disbursed by the banks). Higher the assets, higher should be the capital by the bank.
RBI has mandated banks to keep to maintain 13 per cent for first 3 years. However, NOFHC shall maintain minimum CRAR as per applicable Basel III norms that suggest 9 per cent on an ongoing basis.
source: research at Indigenous Investors
Most of the Indian banks comply very well with these rules of CRAR. However, the top 5 banks – Bandhan, CSB, HDFC Bank, Kotak Bank and DCB simply seem to be in a different class by maintaining 2x to 3x of CRAR requirements.
In simple terms it means, they have more firepower than others to lend money. Hence, they could be in a position to lower your interest rates faster than others.
Other banks that mostly comprise of public sector units have a hard time to lower interest rates because of lower CRARs. These have occurred due to large non-performing assets on their balance sheets. As a result, with limited firepower, they are slow to change and much slower to lend you money at cheaper rates.
Please note: This is not a recommendation note on where to get your loans from. Just a view as to why most people are facing difficulties with their interest rates getting lower despite the banking sector and credit growth picking up in India.