Banks : More questions than answers : New pricing regime likely to be introduced to replace MCLR/base rate - Kotak

More questions than answers. RBI's study paper on MCLR transmission recommends that banks adopt external benchmarks in a complete and time-bound manner. Key risks/imponderables, in our view, are (1) much greater volatility in NIM for banks, (2) unlike the asset side, market-linkage of deposit rates is much more challenging, and (3) ability of customers to absorb interest rate spikes as a result of liquidity events in the wholesale funding markets.

Bracing for higher cyclicality in the banking business

RBI's report on Marginal Cost of Funds Based Lending Rate (MCLR) transmission finds several shortcomings and suggests a switchover to external benchmark-based loan pricing of all loans from FY2019. All loan contracts need to adopt an external benchmark by March 2019. Report suggests use of one the three benchmarks - T-bill rate, CD rate and repo rate. In our view, the shift to external benchmarks for loan pricing will lead to greater volatility in spreads. NIM could come under pressure during times of declining interest rates. While RBI allows banks to fix a commercial spread over benchmark, it proposes that the spread be adjusted only to reflect a credit event Another major concern in our view is customer's untested ability to absorb sharp and sudden spikes in interest rates.

Liability side needs correction too

The Indian banking system relies heavily on retail deposits for funding. Consequently, funding cost is relatively stable and slower to adjust. In our view, moving to a model where assets are priced on a marginal rate basis but funded by a largely fixed cost deposit base can lead to banks trying to price-in the risk of negative spreads (e.g. FY2009 post Lehman crisis) through higher spreads over benchmark. Banks need to address this risk through (1) developing a market for retail floating rate deposits, and (2) greater use of interest rate hedging.

Banks with retail deposit franchises are better placed over cycle

We hypothetically compare the movement of spread between cost of deposit and 12-month T-bill for SBI, HDFC Bank and Yes Bank. Banks with a stronger retail deposit franchise will be in a weaker position to absorb spread compression during sharp declines in interest rate markets while benefiting during rising interest rate cycles.

Transmission benefit vs MCLR less evident based on limited history; pressure on yields imminent

We compare the movement in median MCLR rates since its introduction in April 2016 with the benchmarks (T-bill, CD and repo rate). The decline in MCLR of ~90-100 bps is higher than 50-70 bps decline in T-bill (12-month) and repo rate and similar to ~100 bps decline in CD rates. External benchmarks score extra points over MCLR for added transparency and simplicity, but may not lead to greater transmission for a given spread. However there is greater scope for base rates to decline, reflecting lower transmission.

Few questions on the long-term impact on the banking system

We believe the new systems of loan pricing, introduced in recent years, such as MCLR continue to incentivize banks to reduce the duration of liability profile as hedging interest rate risk is being given a higher priority. However, the asset side cash flow duration has not changed as we still have a higher share of housing/infrastructure loans. We worry if taking liquidity risk is desirable in order to achieve better transmission of rates. Given that we are in a declining rate environment with loan growth challenges, focus on greater transmission is warranted but any such initiative needs assessment of through-the-cycle impact of such actions.

Key findings of the study group on monetary transmission

- Transmission from the changes in the policy repo rate has been slow and incomplete under both the base rate and the MCLR systems. Transmission has been better for fresh loans but inadequate for existing loans outstanding.

- Analysis by the group suggests that banks deviated in ad hoc manner from specified methodologies for calculating base rate/MCLR to either inflate the base rate or prevent the base rate from falling in line with the cost of funds.

- While MCLRs could vary across banks, variations in the spreads across banks appear too large to be explained based on bank level business strategy and borrower-level credit risk. Also, spreads charged by some banks seem excessively and consistently large.

- The key findings of a special study on MCLR spreads are (1) large reduction in MCLR was partly offset by some banks by a simultaneous increase in the spread in the form of business strategy premium to reduce the pass-through to lending rates; (2) a lack of documentation of the rationale for fixing business strategy premium for various sectors; (3) some banks did not have any methodology for computing the spread, which was merely treated as a residual arrived at by deducting the MCLR from the actual prevailing lending rate.

Key recommendations

- Banks should re-calculate the base rate immediately by removing/readjusting arbitrary and entirely discretionary components added to the formula. Allow existing borrowers to migrate to MCLR without switching fee.

- Adopt an external benchmark from April 1, 2018, which will be used to price all new loans and move existing BPLR/BR/MCLR loans to new benchmarks by March 2019. Based on RBI's study, out of the identified 13 benchmarks, CD rate, T-bill rate and repo rate are better suited.

- The Study Group is of the view that the decision on the spread over the external benchmark should be left to the commercial judgment of banks. However, the spread fixed at the time of sanction of loans to all borrowers, including corporates, should remain fixed all through the term of the loan, unless there is a clear credit event necessitating a change in the spread.

- The Study Group, also recommends that the periodicity of resetting the interest rates by banks on all floating rate loans, retail as well as corporate, be reduced from once in a year to once in a quarter.

- Banks should accept floating rate bulk deposits directly to one of the three external benchmarks.

Source : Equity Bulls

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