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Money Jan 30, 2013

Why you should not count on lower EMIs despite repo cut

By Vivek Kaul

Newspaper editors are great believers in Newton's third law of motion - that every action has an equal and opposite reaction. So if Reserve Bank of India (RBI) Governor Duvvuri Subbarao cut the repo rate by 0.25 percent, it should immediately translate into banks cutting interest rates on their loans as well. Repo is the interest rate at which the RBI lends to banks.

So if you are the kind who still reads newspapers you would have come to the conclusion by reading today's edition of almost any newspaper that equated monthly instalments (EMIs) on loans are about to take a dip. The logic: now that the RBI has cut the repo rate, it will lead to banks cutting interest rates on various loans as well and pass on the benefits to current customers and prospective customers.

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Banks are lending money at a much faster rate than they are able to raise through deposits. Hence, money is tight

Now only if it was as simple as that. Let's try and understand why.

The basic business model of any bank is very simple. It raises money as deposits at a certain rate of interest and then lends it out at a higher rate of interest. The difference between the interest rate at which it lends and the interest rate at which it borrows is the money that a bank makes.

So for a bank to be able to cut interest rates on its loans it should first be in a position to cut interest rates on its deposits. Now this is where things get interesting.

The loans of banks (non-food lending) over the last one year (between 13 January 2012 and 11 January 2013, which is the latest data available) have grown by around 15.7 percent. During the same period the deposit growth of banks has been at 12.8 percent.

Over the last six months (i.e. between 13 July 2012 and 11 January 2013) the trend is similar. Lending by banks has grown by 6.8 percent whereas deposits have grown by 5.1 percent.

What this means in simple English is that banks are lending money at a much faster rate than they are able to raise through deposits. Hence, money is tight and banks will need to continue offering high rates of interest on their deposits. Given this, they will have to keep charging higher rates of interest on their loans.

And hence lower EMIs won't be possible despite the firm belief of newspaper editors in Newton's Third Law of Motion. If rates fall, they will at best be marginal.

What is interesting is that this trend has been playing out for a while now. In 2011-2012 , bank deposits grew by 13.8 percent whereas loans grew by 16.3 percent. In 2010-2011, the deposits grew by 16.7 percent whereas loans grew by 23.3 percent.

The other metric to look at here is the incremental credit-deposit ratio. For the period of the last six months this stands at 99.3 percent. This means that for every Rs 100 that the bank has raised as a deposit in the last six months it has given out Rs 99.3 as a loan.

Now this is a problematic situation to be in. For every Rs 100 raised as a deposit the bank has to maintain a statutory liquidity ratio of 23 percent, i.e. invest Rs 23 in government bonds.

Banks also need to currently maintain a cash reserve ratio of 4.25 percent with the RBI: for every Rs 100 raised as a deposit the bank needs to maintain Rs 4.25 with RBI as an interest-free deposit. The CRR will come down to 4 percent from 9 February 2013.

So what does this mean? It means that for every Rs 100 raised as a deposit Rs 27.25 (Rs 23 + Rs 4.25) cannot be given out as a loan. The remaining Rs 72.75 (Rs 100 - Rs 27.25) can be loaned out. Even there the bank needs to maintain some cash in its vaults to pay people who may be withdrawing money from the bank.

So given all this, for every Rs 100 that a bank raises as a deposit it can basically loan out around Rs 65-70. But in the last six months the banks have loaned almost every rupee that they have raised as a deposit.

How has that been possible? That has been possible because banks have been withdrawing money that they had invested in government bonds in the previous years and given some of that money as loans.

This is something that may not be possible forever because banks needs to maintain a SLR of 23 percent. They can't go below that. As TN Ninan wrote in the Business Standard some time back: "In the last two of these years, the credit growth rate (i.e. the loan growth rate) outpaced that of deposits; as should be obvious, this cannot go on indefinitely. And here's the thing; nearly 40 percent of the lower credit growth over the past year has been financed by a drop in banks' investment in government securities; so a good bit of the money that has been lent has not come from customer deposits. Banks could continue to pull money out of government securities, but if they did that the government would not be able to finance its deficit."

In this scenario where banks are lending out almost every bit of the money they are raising as deposits it is difficult for them to cut interest rates on their deposits and hence on their loans.

The only way bank interest rates can come down is if the government borrowings come down. And that is only possible if the government is able to manage its burgeoning fiscal deficit. Whether that happens on that your guess is as good as mine.

Meanwhile, newspaper editors will continue to believe in Newton's third law of motion.

Vivek Kaul is a writer. He can be reached at vivek.kaul@gmail.com

by Vivek Kaul

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