Excess Liquidity and Pricing of Credit Risk. Are We Doing Enough, Asks SBI
Moneylife Digital Team 21 September 2021
In the aftermath of the pandemic, the Reserve Bank of India (RBI) has been at the forefront of stabilising the financial system to keep liquidity in surplus mode. The average net durable liquidity injected into the banking system since April 2021 is at Rs9.3 lakh crore. However, the excess liquidity is creating credit risk for financial institutions, says a research note. 
In the report, Dr Soumya Kanti Ghosh, group chief economic adviser of State Bank of India (SBI), says, "The problem of weak credit demand and excess liquidity is evident from the average reverse repo at Rs7 lakh crore since April and the Union government cash balances with RBI at Rs3.4 lakh crore. Not surprisingly, the SBI Financial Stability Index reflecting all the surplus liquidity and credit spreads were at the highest level in August 2021 since April 2020." 
However, against this background, he says it is now pertinent to ask whether the credit risk is getting adequately reflected in pricing. "A back of envelope estimate suggests that the core funding cost of the banking system that includes the cost of deposits, negative carry-on statutory liquidity ratio (SLR) and cash reserve ratio (CRR) and returns on assets (RoA) is currently at 6%, while the reverse repo rate is at 3.35%. Additionally, if we add the cost of provisions to the core funding cost, the total cost comes to around 12%. Clearly, banks are facing significant margin pressures," Dr Ghosh added.
This apart, market sources told SBI that risk premia over and above core funding cost do not reasonably acknowledge the inherent credit risk. For example, it says, 15-year loans are being priced at even lower than 6%, linking with repo pr treasury (T)-bill rates. It is to be noted that 10-year government securities (G-Sec) are currently trading at 6.2%, and by the current pricing trends, this could even gravitate towards 6.0% again. 
"This anomaly not only negates the concept of tenor premium but may create a material risk with regards to the sustainability of such rates in the long term, on which borrowers and banks are basing their financial calculations," the report points out.
The only good thing, SBI says, is that such a pricing war is mainly restricted to AAA borrowers. Three-year term loans are being quoted at close to a 4% repo rate, and seven-year term loans for borrowers below AAA are also quoting a risk premium of 15-20bps (basis points) over the 10-year rates. Working capital loans (WCL) are currently being quoted at a notch above the reverse repo rate at 3.35%.
Interestingly, RBI had proposed the concept of a normally permitted lending limit (NPLL) for the specified borrower, meant to nudge the borrowers to move towards the corporate bonds market, which may lose its importance. In the current situation, corporate bond rate and bank lending rate are showing huge differential.
According to SBI, the commercial paper (CP) market also witnessing significant churn, with banks now almost absent. Non-banking participants like mutual funds, who do not have access to the RBI reverse repo window, are creating pricing pressure in CP market as they are sometimes quoting below RBI reverse repo rate. In fact, it says, the CP market reflects the huge pricing gap between better and lower-rated borrowers.
"It is noteworthy that the industry is replacing its long-term debts with very low-priced CP or working capital demand loan (WCDL), and this will obviously act as an enabler once the investment cycle revives. However, there is the risk of an asset-liability mismatch if the liquidity is withdrawn quickly," the report points out. 
SBI feels that the inflation numbers may not warrant such a decision from RBI; but if core inflation persists in the current range of 6% or above, that might act as a hindrance to continued liquidity abundance. As of now, a low-interest rate regime and low corporate taxes for corporates (taxes were cut in FY19-20) apart from expenditure reduction also contributed to large share buy-backs, with the five years ended August 2021 showing such buy-backs at Rs1.73 lakh crore. In the past three years, the share buy-backs have been around Rs65,421 crore.
RBI has been navigating through the pandemic with a delicate balance. However, SBI says, as it had pointed out, the period of ample surplus liquidity is already witnessing fierce pricing wars across banks, some of which may not reflect credit risk adequately. Perhaps the balancing act is most prominent when it comes in understanding the depositors' and lenders' interest, it says. 
According to the SBI estimate, the total number of depositors in the banking system is around 207 crore, the number of creditors is at 27 crore. The total bank deposits at Rs151 lakh crore constitute Rs102 lakh crore of retail deposits, including senior citizens. 
Clearly, it says, the actual rate of return on bank deposits has been negative for a sizeable period, and with RBI making it abundantly clear that supporting growth is the primary goal, the low banking rate of interest is unlikely to make a northbound movement anytime soon as liquidity continues to be plentiful. This implies that the current bull run in financial markets is possibly a break from the past as households may have got into the bandwagon of self-fulfilling prophecy of a decent return on their investment, it added.
"We thus believe, it is now the opportune time to revisit the taxation of interest on bank deposits, or at least increasing the threshold of exemption for senior citizens," SBI says, adding, "The RBI can also relook at the regulation that does not allow interest rates of the banks to be determined as per age-wise demographics." 
Additionally, while there is no restriction by RBI on benchmarking of loans as against the earlier marginal cost of funds based lending rate (MCLR) and banks are free to use any benchmark published by Financial Benchmarks India Pvt Ltd (FBIL), continued restrictions on not allowing negative spread on MCLR may also be removed. 
This, according to SBI, will help banks to be agile, optimally manage and book quality business without having to expose the entire book to external benchmarks.
1 month ago
I agree with Mr Kamal Garg that the parameters of Soumyakant Ghosh are for inefficient banks. Further, the net interest margin is under pressure for the armchair lending portfolio of housing, real estate and the retail lending. For the manufacturing sector and MSMEs the announced interest rates and the actual paid out by the borrowers the interest rates are high. At least for SBI 6% for provisions is quite high. Credit risk management in the PSBs in general is not up to the mark. In fact, it was a surprise that 98% of top executives of the PSBs have not gone through their own Annual Statement of accounts even randomly. They do their jobs mechanically and those that the computer in front of them direct them to do and what their bosses want them to do. This situation must change if the financial stability scenario has to move for the better. Crossholding their risks through the sale of third party products should not be a tolerable stance.
Kamal Garg
1 month ago
Provisions at 6% is very high. Normally an efficient banks should not have more than 2-3% as provision cost because of bad loans. Secondly ROA at 1% is very less - it should be at least more than 2% - anywhere between 2 to 3% for an efficient bank. It seems that the author has taken a real inefficient bank's working parameters to arrive at these figures.
However, this is the general scenario in the economy and banking industry and that's why a more efficient banker earns better returns than an inefficient one.
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