Can there be an ideal prime lending rate: Economic Times: 6th May 2009

One of the grievances of industry is that banks are not lowering their lending rates even when the reverse repo and repo rates have been reduced.
The Reserve Bank of India (RBI) too has voiced its concern over the banks’ intransigence. Is this view justified? Is it possible to calculate an ideal prime lending rate (PLR)? To do this, we can pose the question as to what is the cost that a bank has to bear for providing a loan of Rs 100. There are five components that have to be taken into account. These are: the cost of deposits, return on assets (which is the profit that has to be earned ultimately), possibility of a non-performing assets (NPA) and operating expenses. To this we need to subtract the return on investments, which would be earned on the deposits over and above the Rs 100 that have to be garnered to be able to lend Rs 100 as 30% of the deposits have to be set aside for cash reserve ratio (CRR) and statutory liquidity ratio (SLR) on which the latter earns this return. Based on the performance of scheduled commercial banks in FY08, certain thumb rules can be ascertained. The first is that to lend Rs 100, a bank will have to pick up deposits of Rs 140, wherein after setting aside SLR and CRR of 30% the balance 100 can be used for credit. The second is that total assets of banks are 1.3 times the size of deposits, which means that the balance sheet size has to be Rs 180. The third is that 1% return on assets to be paid to shareholders. Fourthly, the operating expenses for the system, as a whole, are 1.8% of total assets. Fifthly, in 2007-08, the ratio of incremental gross non-performing assets to incremental bank credit was around 1.2%. Sixthly, term deposits constitute around 65% savings 22% demand and 13% of total deposits. Here, it may be assumed that term deposits cost 8%, while savings deposits cost 3.5%. Lastly, the return on investments of banks would vary between 6-7%, which compensates for the cost of deposits on the SLR component. The table above gives the calculation of the PLR, in terms of the basic cost to be covered on a loan for Rs 100. The important takeaway here is that the PLR would, under the current circumstances work out to 12.5%, which is on the upper end of the present range. Let us now look at the various components of the PLR to see if they can be negotiated. The cost of deposits is actually very low because there is a component which comes free of cost to banks or at a very low rate. The effective cost of the demand and savings deposits component is just 1%. Further, the return of 8% on term deposit is reasonable as the household confronts not the WPI but the CPI which is 9.6-10.8%. Moreover, banks are answerable to the shareholders and have to deliver profits and, hence the 1% ratio to total assets is intractable. The NPA provision is a direct result of the behaviour of borrowers, and their debt-servicing record must improve to lower this number. Recently, Crisil warned that the level of NPAs in banks could increase. If this is so, it is even more essential to make these provisions. Operating expenses of banks at 1.8% of total assets are much lower than that of the manufacturing sector, where the ratio is around 14% and cannot be brought down. Hence, there is really limited scope for reduction in the PLR and even a 100 bps cut in term deposit rates will lower the cost by 65 bps bringing the PLR down to 11.6%, which is at the lower end of the present range. We have heard of banks which are charging single-digit lending rates. Quite clearly, there is need for introspection and further enquiry, for the cost of the last three components of 6.25% is not tractable; and there could just be a drift away from prudence under all-round pressure to reduce rates.