D P Roy : Structural Issues Remain

D P Roy

Chairman

SBI Capital Markets

The monetary and credit policy indicates measures aimed at the overall growth of the economy as whole.

A rate cut will reduce yields of banks on advances which are on a floating rate basis, while cost of deposits, being of a fixed nature, can only come down with a lag.

The fall will be compensated by higher returns on investments particularly with availability of funds from reduction of CRR by 0.25.

Given the contrarian effect, banks running an active treasury should be able to take advantage of the soft interest rate regime expected to prevail during entire current fiscal.

 

The rate cut also augurs well for the exchange rate with the outlook on the rupee expected to remain stable for the next couple of quarters.

Policy measures get transmitted to the economy through a two-stage process with the RBI move leading to a fall in interest rates across the spectrum and the low rates stimulating consumption and demand, providing the counter-cyclical stimulus to the economy.

India is currently facing a bottleneck at the first stage itself with the fall in risk-free rates not being transmitted to overall lending rates.

The problem at hand is structural. First, the huge non-performing assets levels ensure that the credit risk spread remains high. Moreover, the spread is relatively higher in case of lower-rated borrowers resulting in the aberration of small borrowers subsidising the larger ones.

Second, a lack of will to free the small savings rate ensures that the cost of funds of the banking system remains high.

Although the policy does recognise this structural problem at hand, it fails to provide any concrete measure so as to enhance the transmission effectiveness of the policy.

Another discrepancy prevalent in the economy is the aberration in the concept of PLR. With banks lending at sub-PLR to their preferred clients, the significance of the PLR has been lost.

With sub-PLR levels of 2-2.5% not uncommon and an upper cap at around 3.50-4.00 %, the credit spread prevalent in the economy is huge at 5.50-6.50%.

This is in sharp contrast to the conditions existing in global economies where the PLR (or the base rate as it is called elsewhere) is regarded as a sacrosanct rate whose value is completely determined by the cost of funds and operating expenses. Sub-PLR lending is an extremely rare phenomenon.

RBI efforts to coax the banks to launch floating rate products on the liability side needs to be lauded in the context of the present interest rate scenario and the need to manage the interest rate risk.

However, retail clients (particularly high net-worth individuals) have to be educated as regards the features of the floating rate products and the benefits that accrue to them.

Structuring the floating rate liability is also of paramount importance with special emphasis required on the benchmarks to be selected, the spread over the same, and any additional comfort features necessary like caps and floors.

SBI Capital Markets has already developed a product covering key components of a floating rate liability product i.e. the benchmark rate, spread over benchmark and calculating floor, and caps, and circulated it to a number of banks in May 2001 followed by selective presentation.

The flexibility provided to banks and financial institutions to issue certificate of deposits at floating rates should provide the issuers as well as investors another instrument to manage their balance sheet.

The central bank support of know your customer norms, although a step in the right direction, needs to be supplemented by passing the money laundering bill which is before the Parliament for the last couple of years.

In more advanced economies, financial institutions and banks are regulated through the ROCA system, while we still follow the earlier CAMEL-based supervision which they gave up about five years ago.

In the light of the changes happening across the world, RBI intention of switching over to risk-based system where operational risks (the cause of several mishaps in banks) are given special emphasis is a welcome move, which shall further enhance the stability of our financial system.

Although the policy did live up to the expectations of bond markets, a couple of structural issues, as discussed above, remain in the economy, which need to he addressed immediately.