Do only central bank rates drive bank interest rates?

No, if the recent trends relating to movements in Indian commercial banks’ deposit/ lending rates vis-à-vis the central bank’s (RBI) interest rate reductions are any indication.

A noteworthy feature of interest rate developments in India in the past four months has been that movements in commercial bank interest rates – both deposit and lending – have not kept pace with the steep reductions in the RBI’s reference rates – the reverse repo and the repo. Bank deposit rates have been a little sticky in their decline from their recent highs around 10 per cent plus. Consequently, bank lending rates too have not declined at the pace that policy makers would have liked.

Asymmetry between RBI and banks’ moves

The RBI’s reference interest rates or the rates at which it borrows from and lends to commercial banks have declined by 3.50 percentage points between October 2008 and now. This is in addition to a reduction of 4 percentage points in the level of cash reserves which banks have to maintain against their deposit liabilities.

Apart from the direct infusion of liquidity through the CRR reductions, further liquidity cushion has been provided in the form of a reduced SLR also for banks. All in all, there have been considerable reductions in both signal (reference) interest rates as well as infusion of liquidity of close to Rs.300,000 crore.

The results though have been quite muted. While deposit rates for shorter maturities have declined by around 1 to 1.50 per cent, rates for the longer maturities—ie. three years and above—have either stayed the same or have even increased by around 50 to 100 basis points. Lending rates have reflected the stickiness in deposit rates, declining modestly by around 1 to 1.50 per cent.

Factors beyond RBI’s signal rates

Economic forces, beyond the RBI’s signal interest rates, are having a key determining influence on the direction and level of bank interest rates. The balance sheet composition of individual banks, their liquidity considerations and how an individual bank reacts to competitive pressures in the market place are the three key factors influencing bank interest rates now over and above the signal provided by the RBI.

The fact that, at the aggregate level, longer term deposit rates have not declined commensurately, or have even hardened a little in the past four months, suggests that from a balance sheet perspective, banks want to increase their portfolio of longer term funding. That is, it is quite possible that higher deposit rates for the longer term are a strategy to minimise or mitigate the structural maturity mismatches between liabilities and assets on bank balance sheets. This is quite plausible if one notes that Indian commercial banks’ long-term lending has increased noticeably in the past few years – particularly to sectors such as infrastructure. Apart from infrastructure funding, there has also been considerable term funding for expansion projects in traditional industry segments such as textiles, auto components and light engineering in the past six to seven years.

Another key driver of bank interest rates is the level of existing liquidity and the need for new liquidity on the balance sheet. With so much of liquidity (around Rs.300,000 crore) being infused from the asset side of bank balance sheets, the need for increasing the deposit base (which always is the core and most enduring source of liquidity) through higher deposit rates should ideally be quite weak. There should even be a significant reduction in deposit interest rates in this scenario. The fact that such a notable cut in deposit rates is not happening at the overall industry level probably points to the priority banks are now attaching to better maturity balancing on their balance sheets. That is, balance sheet structuring is now more important than reducing deposit rates to tackle the liquidity being created on the asset side.

Last but not the least, interest rate moves by the competition also have a key influence on how individual banks determine their own interest rates structure. We in India are quite used to commercial banks saying that they are waiting for the industry leader or some segment of the industry to take the lead in setting interest rates. Competitive pressures are at play here and even if an individual bank doesn’t need to raise deposit rates – if its balance sheet and liquidity positions are quite comfortable – it may well have to do so if its
competition is doing that.