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Posted by: Uma Shashikant and Deepa Vasudevan on Thu, Dec 18th, 2014

How do banks respond to RBI's Rate Actions? Part 2: What are banks likely to do now, should RBI cut rates?

The situation in 2014, as the market awaits rate cuts from RBI, is exactly the opposite of what we saw in 2012 (see part 1 of this blog for that story on transmission of RBI’s interest rate policy): deposit growth has been much stronger than growth in bank credit (Pic 1). This build up in deposits has encouraged several banks to drop deposit rates. Overall liquidity is comfortable. Debt yields have fallen across tenors. Inflation is low, and declining. It is fairly certain that interest rates will be reduced next year. Despite all these favourable factors, base rates have remained at 10% for more than a year. Why have rates not declined? Some banks have announced that they will cut lending rates in April, but most remain uncommitted

 

Pic 1 Fortnightly Growth in Bank Deposits and Credit 

Fortnightly Growth in Bank Deposits and Credit

Source: RBI

 

To answer this question, we need to look how banks raise their funds. Deposits are the primary source of funds of banks. As on November 28, 2014, deposits (savings deposits, current accounts, and time deposits) made up 91% of bank liabilities. Banks are not significantly dependent on the money market for funds. During periods of tight liquidity, they tend to borrow in the call money market, refinancing from RBI, or issue high-cost Certificates of Deposits (CDs). But when liquidity is ample, as it has been in 2014-15, their dependence on the money market is low. When RBI changes the policy rate, or the repo rate, it directly impacts rates in the money market.

 

The changes in the money market rates operate on the asset side of a bank’s balance sheet. CDs and CPs are market instruments whose prices almost instantaneously respond to rate cuts by RBI.  A corporate borrower has the choice of issuing a CP or borrowing from the bank. When a bank is able to keep its deposit rates low, and therefore enjoy low cost of funds, it is able to price its loans competitively compared to a CP. However, if it has to lean on CDs to raise money, there is not enough spread to lend aggressively; nor is there enough elbowroom to reduce lending rates.  A period of tight liquidity and high dependence on CDs, therefore naturally leads to a fall in growth rates of credit.  The squeeze on bank profitability that comes from a high borrowing rate is eased when liquidity eases. Therefore deposit rates fall first, before lending rates can fall. Even they do so with a lag, since the impact of policy rate changes on deposit rates is indirect, as it operates through changes in interest rate expectations and inflation expectations. Therefore, banks cannot, and do not, match every drop in repo rate with a drop in deposit rates.  There is an inevitable lag.

 

Even if banks are able to reduce deposit rates, the change is only at the margin. Existing deposits continue to be serviced at the older (and higher) rates until maturity. This creates a time lag between a fall in bank deposit rates and an actual drop in their cost of funds. The higher the proportion of longer tenor deposits in bank balance sheets, the longer it takes for a drop in deposit rates to reduce overall cost of funds. As on March 2013, 13% of the term deposits of scheduled commercial banks were for tenors upto 1 year, 50% for tenors of 1 to 3 years, and 36% for tenors over 3 years! Given the tilt towards long term deposits, it is not surprising that banks are reluctant to pass on the advantage of lower deposit rates by cutting their lending rates.

 

There are more stories to tell about the structural differences between PSU and private banks, and the burden of NPAs on bank balance sheets, which will constrain their pricing and lending actions. Those will have to wait until we are able to see the banking sector results for FY 2015 in April.  In the JFM quarter no one speaks about reducing lending rates, given the seasonal tightness, anyway. Those stories can therefore wait.

Suresh Chauhan on Tue, Jan 13th, 2015 11:25:04 pm

Interesting,informative and easy to understand the responses of Banks to RBI's rate cut

Ajit Purohit on Mon, Dec 22nd, 2014 5:38:37 pm

Informative & made easy to understand the complex subject.

Suman Kumari on Mon, Dec 22nd, 2014 11:43:29 am

Very good article about interest rate and market sentiment

Guru Vittal on Mon, Dec 22nd, 2014 10:51:25 am

Simple to understand the difficult subject and awaiting for Part 2

Jay Thakkar on Sun, Dec 21st, 2014 4:05:54 pm

I read all your articles whether Email or News Paper.Really very informative.Helpful.Pl continue doing excellent job.

murugesan on Sun, Dec 21st, 2014 12:18:12 pm

very good easy explanation on the subject

T Kalyanaraman on Sat, Dec 20th, 2014 9:04:17 pm

of 91% liability on bank's balance sheet what percentage will be CASA. They are nil cost and low cost funds. True they can be called back at any time, however this does not happen all the time - there will be in flows also. This information may givesome more light why or how banks can reduce policy rate or reduce lag while interest rated fall.

jagdish dalal on Sat, Dec 20th, 2014 8:59:07 am

informative article

krishna kishor tiwari on Sat, Dec 20th, 2014 8:35:10 am

The article is very good for all of us for understanding the jargons of financial world.however my comment are as under Banks should have reduced their base rates in view of ample liqudity and should have not created there high cost deposit liability.recently RBI to suck the liquidity has auctioned repo @ nearly 8%. however certain banks will start reducing base rates,other may delay till their high cost deposits is cleared.

Vishal Rastogi on Sat, Dec 20th, 2014 6:34:21 am

such an easy illustration of the complex subject..........Thanks a lot !

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