Why EMIs and interest rates fall more on front pages of newspapers than real life

Oct 8, 2015

- By Vivek Kaul

Vivek Kaul
Regular readers of The Daily Reckoning would know that I am not a great believer in the repo rate cuts leading to an increase in home buying and as well as consumption, with people borrowing and spending more, at lower interest rates.Repo rate is the rate at which the Reserve Bank of India (RBI) lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

A basic reason is that the difference in EMIs after the rate cut is not significant enough to prod people to borrow and buy things. Further, they should be able to afford paying the EMI in the first place, which many of them can't these days, at least when it comes to home loan EMIs.

These reasons apart there is another problem, which the mainstream media doesn't talk about enough. All they seem to come up with are fancy tables on how interest rates and EMIs are going to fall and how this is going to revive the economy. And howacche dinare almost here. Now only if it was as simple as that.

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A cut in the repo rate is not translated into exact cuts in bank lending rates. After any repo rate cut, banks quickly cut their deposit rates. They cut their lending rates as well, but not by the same quantum.

As a recent study carried out by India Ratings and Research points out:"In the recent policy cycle, RBI has cut policy rates since January 2015 by a cumulative 125 basis points, banks have cut one year deposit rates by an average 130 basis points and lending by 50 basis points, which includes the base rate cuts in the last one week. Base rate is the rate below which a bank cannot lend. In the last 18 months three-month commercial paper and certificate of deposit rates have fallen by 150 basis points. Thus transmission of policy rates has been more through market rates and banks deposit rates in the last one year." One basis point is one hundredth of a percentage.

In an ideal world, a 125 basis points cut in the repo rate by the RBI should have led to a 125 basis points cut in the lending as well as deposit rates. But that doesn't seem to have happened. While the one-year deposit rates have been cut by 130 basis points, the lending rates have gone down by just 50 basis points.

And this is a trend which is not just limited to the current spate of rate cuts by the RBI. This is how things have played out in the past as well. As Crisil Research had pointed out in a report released in February 2015: "Lending rates show upward flexibility during monetary tightening but downward rigidity during easing. Between 2002 and 2004, while the policy rate declined by 200 basis points, lending rates dropped by just 90-100 basis points. Conversely, in 2011-12, when the policy rate rose by 170 basis points, lending rates surged 150 basis points."

So, the point being that when the RBI starts to raise the repo rate, banks are quick to pass on the rate increase to their borrowers, but the vice-versa is not true. As India Ratings and Research points out: "The policy cycle is being used by banks to their advantage. A study of the last 10 years shows, that in most cases when policy rates have reduced, deposit rates have comedown faster and the quantum has also been higher compared to lending rates. The same was also true when policy rates were hiked, where lending rates went up and the quantum was also higher compared to deposit rates."

Also, this time around banks have been quick to cut their base rates,the minimum interest rate a bank charges its customers,after the RBI cut the repo rate by 50 basis points to 6.75%, in September. Having cut their base rates, banks have increased their spreads, and negated the cut in base rate to some extent.

Take the case of the State bank of India.The country's largest bank cut its base rateby 40 basis points to 9.3%, in response to RBI cutting the repo rate by 40 basis points.

This meant that the interest rate on home loans should have fallen by 40 basis points as well. Nevertheless, the interest rate on an SBI home loan will fall by only 20 basis points. Why is that? Earlier, the bank gave out home loans to men at five basis points above its base rate (or what is known as thespread). To women, the bank gave out home loans at the base rate. Now it has decided to give out home loans to men at 25 basis points above the base rate. In case of women it is 20 basis points.

Hence, interest rate on a SBI home loan taken by a man will be now be 9.55% (9.3% base rate plus 25 basis points). Earlier, the interest rate was 9.75%. This means a fall in interest rate of 20 basis points only and not 40 basis points, as should have been the case.

ICICI Bank has done something along similar lines as well. And this step has essentially negated the cut in the base rate to some extent.

Further, the public sector banks have a problem of huge bad loans, which are piling on. Given this, they are using this opportunity to ensure that they are able to increase the spread between the interest they charge on their loans and the interest they pay on their deposits. This extra spread will translate into extra profit which can hopefully take care of the bad loans that are piling up.

The bad loans will also limit the ability of banks to cut their lending rates. As Crisil Research points out: "High non-performingassets [NPAs] curbthe pace at which benefits of lower policy rate are passed on to borrowers. Data shows periods of high NPAs - such as between 2002 and 2004 (when NPAs were at 8.8% of gross advances) - are accompanied by weaker transmission of policy rate cuts. This time around, NPA levels are not as high as witnessed back then, but still remain in the zone of discomfort."

Another reason banks often give for not cutting interest rates is the presence of small savings scheme which continue to give high interest when banks are expected to cut interest rates. As India Research and Ratings points out: "In the last decade small saving deposit schemes have offered rates between 8-9.3% unrelated to the up-cycle or down-cycle in policy rates. These rates are also politically sensitive since a bulk of this saving is made by elders, farmers and low income groups. In fact in 2009 when repo rates were at a low of 4.75%, PPF and NSC both continued to offer 8% return and in 2012 when the repo rate moved up to 8.5%, PPF offered 8.8% and NSC offered 8.6% return."

Nevertheless, this time around banks have cut interest rates on their one year deposits by 130 basis points. This is more than the 125 basis points repo rate cut carried out by the RBI during the course of this year.

A more informed conclusion could have been drawn here if there was data available on the kind of interest rate cuts that banks have carried out on their fixed deposits of five years or more. This would have allowed us to carry out a comparison with small savings scheme which typically tend to attract long term savings.

Long story short-EMIs and interest rates fall more on the front pages of business newspapers than they do in real life.

Publisher's Note: Vivek Kaul, the India Editor of the Daily Reckoning, just made a bold call - Real Estate prices are headed for a fall. Well, if you are someone who is looking to buy real estate, or is just interested in the space, I recommend you read Vivek's detailed views in his just published report "The (In)Complete Guide To Real Estate". To claim your copy of this Free Report, just reconfirm your Free subscription to the Daily Reckoning...

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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5 Responses to "Why EMIs and interest rates fall more on front pages of newspapers than real life"

Rahul

Oct 16, 2015

This is an excellent Article. The commentators above are talking theoratically... "competition will eventually bring down the lending rates"... truth is that banks work with herd mentality. Have we not seen that you need one of the big three (SBI, ICICI, HDFC) to move in a direction and everybody follows suit within a month. Because in general the difference between their lending rates is less than the cost of switching. Bring down the loan prepayment penalty to zero and then only the market will be competitive. Every fluction in price (interest rates) is used by middlemen (banks) to increase their profit margin. Rajan has been a boon to Indian economy to keep things relatively steady.

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Praveen

Oct 11, 2015

Hi,

This is a very poor article on economics, banking and business.

Following are some pertinent points:
a) There would always be lag between central bank reducing repo rate and commercial banks cutting lending rate. The commercial banks have existing deposits on which they are paying interest. The lending rates would reduce only after gradual decrease in cost of money.
b) In an increasing interest rate cycle banks profitability reduces. So in a decreasing interest rate cycle banks would want to increase their profitability.
c) We have a competitive banking environment. The competition will eventually bring down the lending rates.
d) History of economics have time & again proven that there is a delayed correlation between interest rates and economic activity (business, consumption etc.)

So, end result is EMIs may not fall immediately or excessively but business sentiment will improve. Eventually borrowing will increase.

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Ajay

Oct 8, 2015

The fatigue from having to churn out something on daily basis is quite evident. I suggest consider changing the title to Weekly or Monthly Reckoning. That will save you a lot of copy-pasting effort and us from reading effort. whole page was wasted on what could have been said in 3-4 lines if you had avoided repeating same set of sentences over and over again. Not to mention repeating paragraphs from your very recent posts.

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krishnan vc

Oct 8, 2015

You hit the nail on the head and I do not think you will be popular among the Group which knows nothing about real Finance or banking but put all their thoughts on the pages of the news papers. If you keep doing this type of work YOU WILL BECOME THE MOST UNPOPULAR PERSON AMONG THE MEDIA FRATERNITY.

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Rajagopal Ramanathan

Oct 8, 2015

I wonder how many consumers understand what an EMI means and what it does? We often conclude that Indians are averse to debt and like to pay debt down at the earliest. But does an EMI actually enable this behaviour? What we fail to understand is that an EMI implies equated monthly installment and not equated principal installment (EPI). An EPI facilitates equal principal ammortisation, but makes the monthly instalment variable. The benefit is that per month interest reduces subtantially. The flip side though is that monthly servicing burden is higher. However, shouldn't one think that with such low rental yields, it makes sense to pay down principal faster and therefore pre-pay to reduce their ownership cost?

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