RBI's new loan pricing norm may put banks in a fix

The Reserve Bank of India's (RBI) mandate that requires banks to link loans to an external benchmark, could increase the risk of asset-liability mismatch (ALM) in absence of a liquid derivatives market in the country.

From October 1, banks have been asked to link their retail and SME loans to an external benchmark for faster transmission of policy rates. These benchmarks include the RBI's repo rate, 3-month treasury bills yield, and 6-month treasury bills yield. Most banks have opted for the repo rate which is more predictable as compared to others.

Currently, banks use the Marginal Cost-based Lending Rate (MCLR) to price loans that are mostly fixed in nature. The MCLR is reviewed every month, but may or may not be revised as frequently. But if banks opt for RBI's repo rate as the benchmark, the lending rates on loans may change with the reduction/increase in the policy rate. The interest rate under the external benchmark will have to be reset at least once in three months, while the RBI reviews policy rates every two months.

This may lead to ALM risk in banks' books if they are unable to address the interest rate risk between floating-rate loans and fixed-rate deposits.

"All our liabilities are fixed-rate liabilities since floating rate deposits are not very popular. So, only the asset book will be priced on external benchmarks," said the head of treasury at a private bank.

A mismatch occurs when cash outflows exceed inflows. As per RBI guidelines, a mismatch should not exceed 20 percent of outflows in the time bucket of 1 to 28 days.

A stress test on liquidity risks that was carried out by the RBI, assumed two scenarios- a 50 percent and 100 percent increase in cash outflows in the 1-28 days time bucket. The results indicated that 25 banks under the first scenario and 36 banks under the second scenario may face liquidity stress, RBI said in its June Financial Stability Report.

Banks could turn to interest rate swaps for rescue. However, the swap market in India is largely one-sided. "There is no price maker in that market even if banks are willing to access it," the treasury head said.

An interest rate swap is a contract between two parties that agree to exchange all future interest rate payments forthcoming from a bond or loan. This typically takes place between fixed and floating-rate loans. The aim is to offset the risk of interest rate fluctuation in the future.

In simple terms, both parties have to agree on what is likely to happen with interest rates in the future, based on what they know today. This leads to speculations as the market players will price in the regulator's future moves.

BP Kanungo, Deputy Governor, RBI recently pointed out the interest rate derivatives market in India continues to be lackluster. "There is reasonable liquidity in overnight interest swaps (OIS), but there is no appetite, and hence not much trading in other derivatives including interest rate futures," he said. Also, the OIS is more of a trading instrument and may not be fit for hedging structural mismatches.

The risk also extends to housing finance companies (HFCs) since they borrow from the money market and will have to compete with banks in the home loan segment. "In order to manage liquidity and interest rate risk, HDFC has, in the past, swapped fixed rate non-convertible debentures to MIBOR-linked payouts. We expect more such interest rate swaps," said MB Mahesh, analyst, Kotak Institutional Equities Research, adding that this will lead to an increase in swap costs and basis risks for HFCs.

Another banker said banks may look for a natural hedge in the current situation. For instance, every bank has a set of Current Accounts Savings Accounts (CASA), that remains constant for a few months as customers use only part of these for transaction purposes. This can be converted into term deposits.

"However, the problem is it cannot be done in isolation by any one bank and has to be enforced by the regulator. The best option we believe could be that regulator enforces all incremental bulk deposits henceforth to be repo linked /flexible," Soumya Kanti Ghosh, Group Chief Economic Adviser, State Bank of India said in a report. The RBI's circular, however, only applies to loans and not on deposits as of now.

Bankers are hopeful that the regulator may take some supportive steps to help lenders move to the new benchmarking framework.