India Reduces Banks' Loan-Pricing Flexibility, a Credit Negative for Consumer Lenders

Srikanth Vadlamani, VP - Senior Credit Officer, Financial Institutions Group, Moody's Investors Service Singapore

On 19 January, the Reserve Bank of India (RBI) instituted norms requiring banks to outline the framework they use to set spreads on loans above their benchmark lending rates. The new requirements are credit negative because they will reduce banks' discretion to price loans at higher spreads to correspond to market conditions and each borrower's creditworthiness.

The norms are likely to most affect consumer loan pricing given that retail borrowers tend to have less pricing power than large industrial borrowers and banks have been most able to take advantage of market inefficiencies in the retail loan segment. Within the retail segment, pricing in the mortgage segment is likely to be the most affected as it is in this segment that banks have resorted to differential pricing the most. Among our rated Indian banks, ICICI Bank (Baa3 stable, D+/baa3 stable ) and Axis Bank (Baa3 stable, D+/baa3 stable) have a high share of mortgage loans in their overall loan books.

Indian banks are required to set a base lending rate that is a function of the bank's cost of funding, operating costs and cost of capital. Although banks are not allowed to lend at rates below their base rate, they have latitude in how they charge a premium or spread on individual loans, depending on market conditions and the credit quality of the specific borrower.

RBI's concern about the transparency and fairness of how banks determine loan spreads mainly relate to the downward stickiness of lending rates (i.e., lending rates not declining commensurately with other interest rates), discriminatory treatment of old borrowers versus new borrowers and arbitrary changes in spreads. Bank spreads are a function of product-specific operating costs, credit risk premium, the loan tenor and qualitative factors such as competitive intensity and pricing power. The regulator has been concerned that arbitrary inclusion of these qualitative factors into product pricing can lead to spread disparities among customers. The new norms address this by requiring banks to have a board-approved policy delineating the spread components. We expect this to reduce the arbitrariness in determining spreads for specific customers.

Moreover, the spread charged to an existing borrower may not be increased except on account of deterioration in the borrower's risk profile or when market interest rates for that particular loan tenor have increased. If a bank decides to change its spreads because of a change in market interest rates for a particular loan tenor, the change will also be applied to all the bank's borrowers at that particular tenor.

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