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Markets will remain closed on May 13, 2021 on account of Id-Ul-Fitr (Ramzan Id).

Bond Markets and the Threat to Banks
Wed, 7 Sep Pre-Open

Whenever corporates require a loan, (whether short term or long term) the bank is the only option for most of them. Now a bank's lending rate depends on its base rate. The base rate is the reference interest rate based on which a bank lends to its creditworthy borrowers.

A host of factors, like the cost of deposits, administrative costs, the repo rate, a bank's profitability in the previous financial year, and a few other parameters, with stipulated weights, are considered while calculating a bank's lending rate.

Now, whenever the RBI reduces the repo rate, it incentives banks to borrow from the central bank at a cheaper rate. This, in turn, reduces the lending rate/base rate of the bank. So a reduction in the repo rate should be followed by a reduction in the lending rate. However, this is not the case.

Banks are holding back their lending rates from falling and therefore, interest rates continue to remain more or less where it was a few quarters back. This means, despite reducing repo rate by 100 bps in the last 18 months, banks continue to be parsimonious with their lending rates. This means, retail customers, and lower rated firms and a vast lot of small and medium enterprises dependent on bank loans -have no avenue to tap but look up to banks for their funding needs.

But there is another option. The bond market. It is where yields are falling, responding to central bank's repo rate. No wonder, then, that the banks are losing their business to the bond market, as better rated firms swarm the market with their bond offerings, which are also bought by the banks as investments. According to Moody's estimate, the corporate bond market amounts to 31% of total credit to the corporate sector in India.

Big and well-rated corporates are now unlikely to head to banks for loans, as the difference between lending rates and the bond yields will continue for a long time to come. Thus, banks are losing out big time and are building up systemic risk for themselves.

As the bigger corporates shift to the bond market route, banks are increasingly ending up with risky clients. These clients cannot hope to raise money through the bond route. This is because the bond market requires rating appraisals and these risky companies would possibly get a junk rating. If banks are not careful, they are going to really put their depositors' money at risk. With this, banks will be raising the prospect of asset quality stress that banks are still suffering from.

However, recently, the RBI stated that it will cap exposure of banks to lend to large borrowers. Further, it will also take steps to deepen the corporate bond market. By limiting banks' ability to lend beyond a level to highly leveraged companies, the central bank is making sure that the firms themselves tap the market and not overburden the banking system, especially in cases of long-gestation project loans. While the central bank has become impatient on banks not lowering the rates, it is also creating the environment for firms to shun banks for a large part of their credit requirements.

Banks have been reluctant to pass on any rate cuts from the central bank to corporate customers as they need capital to fix their balance sheet. This means it is more attractive for companies to issue debt than depending upon their bankers.

Will the banks reduce their lending rates in the coming months? It's anybody's guess.

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