Lower banks’ intermediation spreads: Financial Express 5th June 2017

When the RBI Deputy Governor talks of the need for banks to charge customers more moderately, it can be construed as a wakeup call.

When the RBI Deputy Governor talks of the need for banks to charge customers more moderately, it can be construed as a wakeup call. With deregulation, banks have the freedom to charge for everything when the account is not in the category of ‘inclusive banking’ which has tended to make banking with one’s own deposit an expensive affair. One can be charged for cheques, entry to the bank, dealing with cash, using ATMs, etc. The explanation given is that when the bank is providing you with premium service, then it has a right to charge for the same. Banks first moved customers from the counter to the ATM to “save costs”, and now are charging them for access to both the modes beyond a point. And given the near oligopolistic nature of the system, everyone ends up charging the same amount and the customer has little choice.

Critics have raised some queries here. A pertinent issue is that while every bank is cost-conscious and justifies charges on grounds of additional costs being imposed on their profits and shareholder value, the fact remains that banks use deposit-holders’ money to make their money. There is already a charge on deposit-holders in terms of being paid a lower interest compared to what banks receive on loans, which is called the cost of intermediation. But, there is a problem of NPAs, where money at the end of the day is not put to the best use—which is what banks were supposed to do on behalf of the ultimate saver—and is often termed as a case of failed intermediation. And interestingly, unlike any other public limited company which provides capital to the enterprise, a bank runs on deposit-holders’ money and yet punishes them for every breath of air inhaled.

The actual spreads of banks in India are amazingly high. RBI provides data of the average rate charged by banks on outstanding loans as well as fresh loans. Also the average interest on term deposits is available, and given that 65% of deposits are term deposits, 10% in current account (zero interest) and 25% in savings account (25% at 4%), there is a lot of free money also available to banks. The accompanying table provides some interesting information.

The cost of intermediation is hence quite high, at above 5%, when reckoned on the basis of outstanding loans and around 100 bps lower on fresh loans. Banks always justify the stickiness in lowering lending rates as only new deposits are re-priced while all loans are reckoned at new rates. By using the concepts of average cost of deposits and average return on loans, this constraint is eased.

Is such a high cost of intermediation fair for the deposit-holder who can actually get a much higher rate theoretically if the money goes directly to the company? The theory of intermediation does state that besides the flexibility provided to deposit-holders on money kept with the bank (which can be contested today since every action is actually charged separately), banks need to charge for superior risk analytics as they bridge the asymmetry between the lender and borrower with specialised knowledge. However, the NPA story over the last 5-6 years shows there were flaws in the process—both in terms of evaluation and recognition of impaired assets and banks have not quite redeemed themselves. Would it really be fair for the deposit holder to see their money not being put to prudent use?

This issue is important because the provisions being made for NPAs can be brought into the picture. Based on FY16 ratios, around 85% provisions were made for NPAs. Assuming similar proportions prevail for FY17, the ratio of provisions to outstanding deposits would be in the range of 1.8-2.1%. From the deposit-holders’ perspective, the intermediary is actually giving the deposit-holder an interest rate of 5.6% and taking a spread of 4-5% (depending on fresh loans or o/s loans) and making a provision for what can be termed as ‘failure in intermediation’ of 2%. Intuitively if banks were able to evaluate risk better, they should be in a position to either reward deposit-holders better or charge lower rates to borrowers.

There is hence a case for the structure of interest rates of banks being revisited to ensure that the spreads are minimised. Maintaining high spreads which act as a useful cover for weak credit assessment is just neither justified nor sustainable. There is this constant clamour that RBI lower interest rates. Almost 10 out of 10 commentaries on interest rates always ask for rate-cuts even though just by lowering rates, one cannot make corporates or individuals borrow. The result has been that banks have tended to push business by offering loans with relatively less stringent standards. The result is that not only do banks continue to charge higher rates to lower rated companies (as the MCLR of 8% as of March 2017 matched with 9.72% for rate charged on fresh loans) but also have built up an unhealthy portfolio.

Deposit-holders, for their part, are in a tight spot as there are few avenues for venting their grievances as they are not organised. Demonetisation revealed that deposit-holders are yet to get used to the electronic medium and the fact that currency is coming back into the system means that cash is the most preferred mode of transactions. Customers probably do have a right to voice their concern over the banking charges of various services. Given that banks are operating on very high intermediation spreads, there is a hence strong case for lowering them