Why the Loan Interest Rates Are Not Falling Sharply?

The Reserve Bank of India has cut Repo rate by 110 basis points since the beginning of the year (2019). However, the banks have reduced their weighted average lending rates by 29 bps. If you have a floating rate home loan, then this news is not very comforting.

This is a very common grievance for the loan borrowers. The banks are quick to increase loan rates when RBI increases repo rates but are never so keen to reduce rates when the RBI cuts repo rates. It is a cause of worry for the Reserve Bank too. If the rate cuts are not passed onto the borrowers, the policy transmission gets impeded. The repo rate cuts may not yield the desired effect to the economy. After all, the Repo rate is the rate at which the Reserve Bank lends to the banks. The RBI does not lend directly to the end users. For this reason, the RBI had advised banks to shift to external benchmark to price loans from April 1, 2019. The proposal has since been put on hold. Despite this, the State Bank of India started offerings a repo-rate linked home loan product in July 2019.

We wouldn’t have to worry about all this if the banks were passing on the rate cuts to their borrowers. What could be the reason? Well, the banks don’t smell of roses. If they could, they would never cut the rates. At the same time, there is a fair bit of competition in the industry. Someone would come and disrupt the industry if the banks were taking the borrowers for a ride. Therefore, there must be some genuine reasons too. In this post, let’s get to the other side of the story and see why the banks may be hesitant in cutting loan interest rates.

Author’s Note: Please understand that my knowledge about how loans are priced is rather limited. In this post, I will attempt to highlight potential reasons. The banking industry is way more complicated and there are many dynamics at play. This post can be starting point for a much deeper research at your end.

Banks Borrow and Lend It Further

The banks raise (or borrow) funds at a certain cost and offer it to borrowers at a higher cost. And that’s how banking industry functions. The banks have many sources of funding including Current and saving account balance, fixed deposit, certificates of deposits, bonds, repo, CBLO, equity etc. MCLR links the lending rates to the cost of incremental funds. Lending rates cannot move aloof of the cost of funding.

If the cost of deposits (funds) does not change much, the banks cannot cut lending rates. Why the deposit rates can’t change? There could be many reasons.

The banks face competition for the public funds not just from the other banks, but from the small savings schemes too. Banking fixed deposits have competition from PPF, SCSS, Post Office fixed deposits too. For instance, PPF and NSC yield close to 8% p.a. Sukanya Samriddhi and Senior Citizens Savings Scheme (SCSS) offer 8.4% p.a. and 8.6% p.a. respectively. Kisan Vikas Patra (KVP) gives 7.6% p.a. Post Office term deposits yield between 6.9% to 7.70 p.a.

See current SBI FD interest rates below.

Struggling to keep up with small savings schemes, aren’t they? Now, the Government is not changing small savings rates when the RBI is cutting repo rates. Since bank fixed deposits compete with small savings schemes for public funds, the bank FD rates cannot be much below the interest rates offered by small savings schemes. Banking fixed deposit is a commodity. Investors won’t mind shifting to another bank or instrument offering a higher rate of interest (at the same level of risk).

Why Doesn’t the Government Cut the Rates on Small Savings Schemes?

The 10-year Government bond yield is around 6.5% p.a. (as on August 13, 2019). The small saving scheme rates look quite high in comparison. By reducing the rates on small savings scheme, the Government stands to benefit. A lower interest rate reduces its interest liability. Why, then, does the Government not cut the small saving scheme interest rates sharply?

An important reason, of course, is that these rates are politically sensitive. Therefore, you can expect the Government to be hesitant in cutting rates. There is perhaps more. This Mint article covers one such reason. This Mint also provides more reasons about why the banks have not been able to reduce deposit rates and lending rates as much.

There Are Other Issues Too

The rate of a bank fixed deposit is fixed for the period. If you open a bank FD for 5 years, you earn the same rate of interest irrespective of what happens in the intervening 5 years. However, the loan interest rate will change on every reset date. The banks must balance this dynamic too.

And then, there are business strategy decisions. Typically, SBI cuts the MCLR or base rate first under Government pressure or otherwise and then the other banks follow. As I said, the banks do not smell of roses. If they could, they could keep cutting the deposit rates and never cut the loan benchmark rates.

What Should You Do?

If you are not happy with your bank, explore shifting to a loan product that is linked to an external benchmark. Even though interest rates under such products can be volatile, you will at least have peace of mind. You will at least not nurse a grouse against your bank.

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