Mumbai: The retail and small business loan portfolio of private banks, wherein they had a competitive edge over state-run banks, could turn out to be a drag on their margins, if interest rates keep falling, analysts said after the Reserve Bank of India’s (RBI’s) mandate to link lending rates to an external benchmark.
The central bank has lowered its repo rate by 110 basis points (bps) since January.
Although the RBI rule does not apply to housing finance companies (HFCs), they are also expected to see a margin squeeze considering that they will have to try and compete with the rates offered by banks.
Margins of private banks seem more susceptible to interest rate volatility because of their greater exposure (as a percentage of their total loans) to retail and small business loans compared to their state-run peers. Among the private banks, only Federal Bank and IDBI Bank have so far linked their lending rates to an external benchmark.
An analysis by Kotak Institutional Equities on 4 September showed that retail and small business loans formed 65% of ICICI Bank’s loan book at the end of fiscal year 2018-19, while it was 41% and 34% for State Bank of India (SBI) and Bank of Baroda (BoB), respectively.
Among public sector banks, SBI, BoB, Allahabad Bank, Bank of India, Union Bank of India, United Bank of India and Central Bank of India, among others, have started offering external benchmark-linked products to borrowers.
To be sure, the external benchmarks will only apply to fresh loans from 1 October. Existing borrowers will have to approach their banks to shift to the new rate.
The RBI has allowed banks to decide on the spread, or the risk premium they charge to a particular borrower, and there are concerns that banks might tweak the spread to guard themselves against volatility. “We can look at increasing risk premia and also tweaking fees on these loans to protect the margins,” a private bank chief executive said on the condition of anonymity.
Brokerage firm CLSA said in a 4 September report that ICICI Bank has a higher share of housing and small business loans, while IndusInd Bank and HDFC Bank have a lower exposure.
Banks can choose the repo rate, the government’s three-month and six-month treasury bill yield published by the Financial Benchmarks India Pvt. Ltd (FBIL), or any other benchmark market interest rate published by FBIL.
“We believe that banks may prefer repo rate as it is less volatile and can be used to benchmark deposit rates,” CLSA said, adding that risks could arise from a sharp cut in repo rate, conversion of loans from old marginal cost of funds based lending rate to new benchmarks and a slower fall in funding costs.
According to Kotak, HFCs could face high volatility in net interest margin after banks migrate retail floating rate loans to external benchmarks. “Large HFCs like HDFC, LIC Housing Finance and PNB Housing Finance compete with banks closely in their retail home loan segment and will need to catch up with their banking peers on any movement in home loan rates,” Kotak said in its report.
While the linking of lending rates to an external benchmark will ensure quicker transmission, both during falling and rising interest rate periods, it would also lead to more volatility for retail borrowers. Anil Gupta, vice president of rating agency Icra Ltd, said chunky changes in RBI repo rates could lead to volatility in monthly repayment obligations of borrowers.
With the RBI issuing guidelines on this, the next step for banks is to link their savings deposit rates to an external benchmark as well to avoid asset liability mismatches. “Banks will look at linking their savings bank account rates to repo rate to ensure that margins remain stable. Since savings bank accounts are sticky in nature, our asset liability will be better managed,” said Papia Sengupta, executive director, Bank of Baroda.