Reshaping India's financial markets

We need to diversify the forex, credit and interest rate risks across the financial market

The decision by the State Bank of India (SBI) to expedite the transmission of policy rate by linking the asset and liability sides could reshape the Indian financial markets. On March 8, the SBI decided to link savings bank (SB) deposits with balances above Rs 1 lakh to the repo rate; all cash credit accounts and overdrafts with limits above Rs 1 lakh will also be linked to the repo rate. The risk premiums over and above the floor rate would continue to be based on the risk profile of the borrower.

SB deposits typically serve the transaction needs of the depositor. Aligning the repo rate with the savings bank rate over the Rs 1 lakh threshold would be a win-win for the bank, customer and the regulator. The option is always available with the customer to shift the extra SB balance to time deposits, which will help the banks to plan their asset-liability management accordingly. Setting the limit at Rs 1 lakh is primarily aimed to protect the small-time depositors from the vagaries of market fluctuations. It may also be noted that the RBI allows a differential interest rate structure for saving bank deposits only beyond Rs 1 lakh and the deposit insurance cover is also applicable up to Rs 1 lakh.

 

The Indian banking sector has a deposit base (as of March '18) of Rs 114 trillion, of which 32.9 per cent or Rs 37 trillion is SB deposits with almost 70 per cent of the SB deposits with public sector banks. Nearly 75 per cent of SB deposits are above Rs 1 lakh and if the banking sector goes ahead with this move then a 25 bps change in the repo rate will have an impact of Rs 70.6 billion on the liability side in either direction. 

On the asset side, for All Schedulad Commercial Banks (ASCBs), the outstanding cash credit (CC) and overdraft (OD) above Rs 1 lakh amount to 22.30 per cent of the total ASCB advances. If all banks link CC/OD to repo rate and there is 25 bps change in repo, the net interest income of ASCB will change by around Rs 49 billion. Furthermore, MCLR linked rates  could change by Rs 22.7 billion, taking the total impact on advances to Rs 71.5 billion. Hence, the total impact of the repo rate change is likely to be net interest margin neutral for the banking sector.

One of the primary reasons for linking the SB rate with the repo rate and not T-bills is that T-bills are more volatile than the policy repo rate and this could introduce a noise element into consumption expenditure of individuals if T-bills are used as an external benchmark. A more compelling argument could be that term deposits with ASCBs have an average balance of Rs 2.75 lakh equivalent to a monthly interest income of Rs 1,610 (at the rate of 7 per cent per annum) against a monthly income of Rs 9,416 (per capita income of Indians is Rs 1.13 lakh). The interest income, therefore, forms up to 17 per cent of the income — too big an amount to be left to the whims of market determined rates. It may be noted that SB interest is around 2 per cent of our private final consumption expenditure, and less prone to market volatilities and hence the decision to link SB is perfectly justified. The volatility in rate movements could result in a concomitant decline in income velocity of money as it could then be used more for precautionary purposes. 

The linking of lending rates to external benchmark also needs to factor in two key developments announced during the last four years. In December 2018, the RBI announced guidelines on the 

minimum level of “loan component” for large corporates that could be carved out of working capital loans. The key intent of the guideline was to instill credit discipline among large borrowers. Large corporates responded to the RBI intent and corporate bond issuances swelled from Rs 5.84 trillion in FY15-16 to Rs 6.77 trillion in FY2017-18, reporting around 8 per cent CAGR. During the nine-month FY19 period, Rs 4.70 trillion has been mobilised. 

Thus, raising corporate bonds/CPs/ECBs/masala bonds/NCDs etc at fine pricing for large well-perceived borrower meant transmission of rates was already being factored in through competitive market offerings, allowing for market decided price discovery. The process of tapering aggregate fund-based credit limit within the scheduled time appears to be running its course. Thus, this SBI step could potentially usher in a better all-round price discovery and complement the current mechanism. 

With India currently a $2.6 trillion economy it is imperative that the interest rate derivative market also expands with this move. Put in a different way, currently, all kinds of risks — be it FX, credit or interest rates —  all are largely warehoused in the banking system and with the 

economy growing, we need to diversify this risk across the financial market. The current step could just be a beginning. 

The author is group chief economic advisor, State Bank of India. Views are personal