The RBI Governor, Dr D. Subbarao…It is difficult to explain the need or justification for the rate hikes.

M. Sitarama Murty

Bowing to pressure from various quarters, including the government, the RBI announced a slew of measures in quick succession to increase liquidity. As an icing on the cake, the repo rate was also brought down by two percentage points.

The response of the banks has been rather subdued and uncertain. Many adopted a wait-and-watch policy. Some promptly announced a cut in deposit rates only to offer higher rates on bulk deposits nullifying the impact. There were some attempts at forming a cartel for bulk deposits. Now almost every bank has brought down the PLR.

During the previous fiscal, much before the full blown financial crisis began to impact the markets, the RBI raised the repo rate and CRR to contain inflation. Banks were in a hurry to fall in line and hiked the rates on deposits and advances. Irrespective of the individual asset liability mix, banks competed in wooing the depositors. If fear of losing market share made a large public sector bank begin the rate war, others quickly followed suit.

The interest rates on deposits were jacked up all the way from 6 per cent (for one year) to 10 per cent. By March end, the cut-throat competition saw the CD market reach a level of 12 per cent. Unmindful of the cost or the need for funds, all banks joined the race.

The high cost of funds necessitated rise in the lending rates. The casualties were the housing and SME sectors, chosen to mitigate the rising NPA problem.

It is difficult to explain the need or justification for the hikes. An increase of 0.25 or 0.50 per cent in the repo rate was at best only a signal to the banks to ration credit and avoid excessive or unproductive lending. The repo rate affects only those banks dependent on borrowings from the RBI for funds management. Normally such borrowings are not more than about 1 per cent of the assets.

A 0.50 or 1 per cent hike in the interest rates on the total assets was, thus, unwarranted. The same logic applies to call money market too. Lenders and borrowers are in the market to even out marginal mismatches in the cash flows and fine tune the CRR requirements.

The amounts involved being a fraction of the total assets, a temporary rise in the call rate should not result in hike in the rates on the entire assets.

Recently, when the RBI reduced CRR, SLR and repo rate and there was a need and justification for southward movement of interest rates, banks were slow to respond. Banks were in a dilemma and buying time, due to the build-up of high cost short and medium term liabilities.

The size of the balance sheet seems to have weighed with the banks when they hiked the deposit rates last time on the eve of the 2007-08 year end. In case of an increase in rates, while most of the assets get re-priced immediately, the increase in cost is only on future deposits. As most banks had mobilised deposits at high rates for periods beyond a year, today the liabilities continue on their books.

In case of downward revision of rates, the assets get re-priced immediately, while the burden on account of liabilities would continue for some time. This happens every time. Attempts to mitigate this problem by marketing deposits at floating rates have not met with success.

And many customers chose the smarter option of converting the existing deposits into fresh deposits at new rates. The huge difference in rates more than took care of the penalties for premature payments. Thus, the banks suffered a double whammy as cost mounted even on the existing deposits.

Statistics indicate that liquidity as such was not a serious problem for the Indian banks to meet the genuine credit needs of productive sectors any time. Credit expansion has not shown any signs of slowdown, the incremental CD ratio exceeding 90 per cent during this fiscal so far.

The credit crunch in the US and the withdrawal of FII funds had impacted the stock markets adversely. Worried about the developments, the consequent upheavals in the exchange markets and depletion of reserves, the government appears to have decided on boosting the liquidity.

In the aftermath of the meltdown, while allocating credit, some banks might have seen an opportunity to set right the anomaly of some corporates getting away with unduly low rates. Only a couple of months ago several banks raised the PLR and some others the interest rates on individual basis, leading to a hue and cry from powerful lobbies. Finally, the active intervention of the government compelled the reluctant banks to bring down the rates. From a position of saying “we will examine”, before the meeting with the Finance Minister, to “possibility of a 0.25 to 0.5 per cent reduction” after the meeting, the banks uniformly brought down their PLR by as much as 0.75 per cent during the last week.

Obviously, no lessons have been learnt from the on-going financial crisis. ALM and risk management mechanisms seem to be more for the regulator’s consumption, the pet phrase of defence being “being practical”. While one can’t be out of market, pricing has to be essentially an offshoot of the ALM process. Decision making has to be more objective and professional.

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