Context

We have a situation in India today where the policy repo rate has been kept low. Banks are just about managing their non-performing assets (NPAs) and there is uncertainty in the air.

Mispricing of capital by banks

• There are different components of the cost of funds for banks, which are captured by the MCLR or marginal cost of funds-based lending rate.
• For every ₹100 deposits that enter the banking system, there are different accompanying costs for the system.
• These are deposit costs, provisioning for NPAs, return on assets (ROA or minimum profit), and the regulatory cost of cash reserve and statutory liquidity ratio balances (CRR and SLR) that perforce have to be held.
• Adding these components, the basic cost works out to be 8.9%, which should be the rate at which incremental lending should take place.
• By offering loans at a much lower rate of 7.23%, the system is actually mispricing capital.
• It may be noted that deposit rates have been compressed to a very large degree and so this cost of 4% is very low.
• Banks do have the advantage of getting free demand deposits and the right to offer differential rates on saving accounts.
• Clearly, deposit-holders are subsidizing borrowers quite significantly.

Issue of NPA provisioning in India

• In the past couple of years, provisions as a proportion of NPAs have averaged 30-40%.
• As NPAs increase, ideally, banks should load this cost onto their borrowers.
• But that rarely happens in India. Instead, it is taken on banks’ books and gets reflected in their balance sheets.
• If NPAs were kept in the region of, say, 4-5% of assets, it would have been possible to bring the cost down to 1.5% (from 3%), which would then have justified the present MCLR.

Low return on assets (ROA)

• The ideal return norm is 1%, which should be derived from all assets.
• This does not happen for banks’ investment portfolios, and the value imputed here is only for loans.
• The ROA for banks is abysmally low, as this aspect does not go into the pricing of products on the asset side.
• Deposit costs have been driven down as savers don’t have a choice.
• But a commensurate return does not materialize in the loan books of banks.

Cost of regulations

• The CRR component gets no compensation, while the SLR part earns around 6%, which is the average cost of fresh borrowing for the Union government.
• While these numbers vary across banks, the minimum rate of 8.9% would hold for the system, which will vary by the level of NPAs.
• The concept of linking benchmarks to certain loans further misprices fresh lending, as those loans are not ideal anchors to use, for they are being manually driven downwards by a deluge of liquidity in the system after the pandemic.
• Excess liquidity of ₹4-7 trillion a day since April 2020 has meant banks have been placing funds costing them 8.9% with the central bank which gives them just 3.35%.
• This is eventually borne by bank shareholders.

Implications

• With rather rigid policies on corporate lending to avert possible NPAs, banks have preferred lending to the retail segment, which is less risky, and small businesses, backed by the Centre’s credit guarantee.
• The central bank’s government-bond buying programme to provide liquidity has been successful.
• But in the absence of fructification of lending and a continuous rollover of funds at the reverse-repo window, Indian banks are bearing a negative carry trade, with a 6% return traded for just 3.35%.

Conclusion

Banks must price capital appropriately and not get overly influenced by arguments in favor of cheap credit or the fact that loans are cheaper in the West. We need to get practical on this issue.

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