Trespassers Allowed
lending by commercial banks and financial institutions. George Albert reports on the fall-out of this decision.
It is open war now. Be it an interest rate tussle or trespassing each others territory, there is a definite blurring in the dividing lines between commercial banks and financial institutions.
Commercial banks have been intimidating FIs by reducing interest rates at regular intervals. For instance from June last year till date, banks have cut the prime lending rates (PLRs) four times, bringing it down from around 15.5 per cent to 14 per cent currently. However, Industrial Development Bank of India (IDBI) cut its rate only once in November 1996. But after the last cut in PLR by many banks to 14 per cent, both IDBI and Industrial Credit and Investment Corporation of India (ICICI) effected a huge 150 basis point cut to bring their PLRs to 15 per cent.
Signs of the rate war became apparent after the last credit policy announced on March 15, 1997. The Reserve Bank of Indias (RBI) decision to scrap the system of maximum permissible bank finance and also give freedom to banks to move away from consortium finance further blurred boundaries. Another breakthrough has been the reduction of reserve requirement on inter bank liabilities. This move is expected to improve the allocating efficiency of the financial system. Says SH Khan, CMD of IDBI, All this set the stage for us to enter the short-term loan market. The short-term market has traditionally been the domain of commercial banks.
By reducing their lending rates, commercial banks were eating into the incremental business of FIs. It forced FIs to cut rates in order to protect their turf. State Bank of India was the first to spark the rate war by cutting its PLR by 50 basis points to 14 per cent. Many other banks Bank of Baroda and Bank of India have followed suit.
However, as the plot thickened, IDBI announced its PLR cut by 150 basis points to 15 per cent. It also announced the decision to enter working capital financing. Khan announced that he would be allocating 15 per cent of their incremental funds to short-term financing. IDBIs plan is to lend to corporates who already have long-term exposure to the institution. And the lending will be done jointly with IDBI Bank and commercial banks, with the FI providing the loan component and the bank providing the cash credit component.
Term lending has predominantly been the turf of FIs. IDBIs entry into short-term lending was essentially prompted, by SBI and other commercial banks who ventured into term lending a few months back.
With both the FIs and banks crossing borders, the war escalated, with ICICI cutting interest rates just a day after IDBI cut its PLR. This despite ICICIs announcement a few days back that the cost of funds had not fallen adequately to warrant a cut in PLR.
ICICI did more than pare its PLR to 15 per cent. It introduced an all new medium-term prime rate (MTPR) at 13.5 per cent to be charged to borrowings below 30 months and the PLR of 15 per cent was christened long-term prime rate (LTPR). ICICIs introduction of the MTPR meant, that for the first time an FI was lending at rates below commercial banks. The MTPR undercut SBIs and other leading banks PLR by 50 basis points.
ICICI has also undercut the IDBIs interest rate in medium-term lending. Where IDBIs rate for medium-term lending is 15 per cent, ICICIs is 13.5 per cent. This essentially means that clients will be attracted to ICICI from IDBI and commercial banks for their short-term borrowing requirements. Says the chairman of a leading public sector bank, the battle on the lending side is expected to spill over even to the resources side, with financial institutions proposing to go aggressively into short-term deposits.
It is commercial banks that raise short to medium term retail deposits. As the initial reactions to the shake out in the financial sector begin to trickle in, the views on the issue of sustainability of the steps taken by the market players are mixed. However, one clear indicator that emerges is that the success of many of the plans hinges on resource mobilisation efforts.
Reacting to the entry of commercial banks into the term lending market, IDBIs Khan said that banks will not be in a position to allocate a major chunk of their portfolio to term lending as they will face an asset-liability mismatch. This is true as most banks have deposits with a maximum tenure of three years. However, long-term loans extend much beyond five years. The result is that banks can get caught in a maturity mismatch. For instance, banks may borrow at an average cost of 10 per cent for three years, and given their high transaction cost, lend at 15 per cent for seven years. Now, if the deposit rate after three years moves up to 12 per cent, the banks will witness a squeeze in margins, which could also lead to losses in their long-term portfolio.
According to M S Verma, chairman, SBI, Financial institutions will never be able to match the cost of funds of commercial banks. He also stated that if FIs enter his turf, SBI would react appropriately. Public sector banks in India have a huge branch network that enables them to raise cheap deposits. These deposits are also more stable in nature, that allows them to venture in term lending without much fear of a mismatch.
However, since FIs have to raise funds at a much higher rate of interest, it will be difficult for them to compete with banks in the short-term market. For instance, the marginal cost of funds for IDBI is still around 16 per cent. This makes it difficult for them to lend at their recently announced PLR of 15 per cent. But since IDBI with its cheap long-term government funds has a low average cost of funds, it can still lend even if the marginal cost of funds is high.
In the case of ICICI, the introduction of MTPR complicates the issue further. At the last bond issue, ICICI had to pay 16.25 per cent but the MTPR is fixed at 13.5 per cent. Says a banker, It is impossible for ICICI to be profitable at these rates. However, an ICICI official claims that they are able to raise one year funds at 11 per cent which they can lend at MTPR.
If indeed, ICICI is able to consistently raise funds at 11 per cent for one year, it can play in the short term market. ICICI, unlike commercial banks, is able to operate on very thin net spreads of around 2.5 percentage points. ICICIs introduction of the MTPR has evoked a lot of scorn from the financial sector. Many see it as an act of bravado.
SBIs Verma feels that no project can be completed in 30 months tenure for which the MTPR applies. Says he, It looks more like bridge loan. On the other hand, Khan has said that ICICI will have to play on the short-term money market like inter-corporate deposits or private placements if it has to lend at 13.5 per cent. Khan himself is not in favour of this policy for IDBI.
Bankers point out that the whole issue boils down to the ability of market players to raise liabilities for the assets they want to create. This means that FIs will have to raise short-term resources and banks long-term resources. And the battle here is about to begin.
FIs have already asked the RBI that they be allowed to raise fixed deposits for tenures much below the current minimum period of three years and also issue certificate of deposits for maturities below the stipulated one year. This will give them access to the short-term liability market.
However, banks have told the RBI that in case FIs are allowed to raise short-term resources, reserve requirement should be imposed on them. This will bring them on par with commercial banks who have to maintain cash reserve ratio and statutory liquidity ratio. The RBI is considering the proposal. Says a banker, As far as banks are concerned, they can go in for fixed deposits for seven years and above to meet the needs of long-term funding. They can also raise money through bonds.
It is felt that the success of the steps initiated by market players depends on their ability to raise the requisite resources. In this area, the RBI needs to bring down the regulatory barriers and create an integrated financial system. Meanwhile, heads of financial intermediaries must take decisions based on business considerations and not one upmanship.
By reducing their lending rates, commercial banks were eating into the incremental business of FIs. It forced FIs to cut rates in order to protect their turf.