Our banks are mispricing capital and this is simply unsustainable

Source: This post is based on the article “Our banks are mispricing capital and this is simply unsustainable” published in Live Mint on 2nd September 2021. 

Syllabus: GS3- Indian Economy

Relevance: Monetary policy and Economic stability 

Synopsis: Below-cost lending in India could have economic repercussions beyond the financial burden imposed on bank shareholders.

Background

We have a situation in India today where the policy repo rate has been kept low, which is reflected in the cost of deposits and consequently lending rates.  

Also, there is talk of loan melas, where the credit must be given. The question that arises is whether we are pricing capital adequately. 

What is the cost borne by the banks? 

For instance, for every ₹100 deposits that enter the banking system, there are accompanying costs for the system. 

These are deposit costs, provisioning for NPAs, return on assets (ROA or minimum profit), and the regulatory cost of cash reserve and statutory liquidity ratio balances (CRR and SLR). 

Adding these components, the basic cost works out to 8.9%, which should be the rate at which incremental lending should take place.  

Hence, by offering loans at a much lower rate of 7.23%, the banking system is actually mispricing the capital. 

Other issues: As NPAs increase, ideally banks should load this cost onto their borrowers. But that rarely happens in India. Instead, it is taken on banks’ books and gets reflected in their balance sheets.  

How does mispricing capital impact the economy? 

Deposit costs have been driven down as savers don’t have a choice. Deposit-holders are subsidizing borrowers quite significantly. 

Loss to bank shareholders: Banks have been placing funds costing them 8.9% with the central bank through its reverse repo window, which gives them just 3.35%. This loss is eventually borne by bank shareholders. 

More lending to small businesses: With rigid policies on corporate lending to avert possible NPAs, banks have preferred lending to the retail segment, which is less risky, and small businesses, backed by the Centre’s credit guarantee.