The Interest Rate Conundrum

Mohit Prakash | 24-Jun-2016

Repo rate, reverse repo rate, cash reserve ratio (CRR). If you are beginning to think that economy and its jargons are not your cups of tea, then you are not alone. Being shrouded in many such lingos, the economic policies have moved farther away from the common people. And though, these policies play an important role in our daily life, we have very little chance of understanding their inner working.

Well, not so anymore, let us give it a try.

So, let us start with the basic question- Will the interest rate on your loans; car loan, home loan decrease in the coming months? We will try to answer this question over the course of this blog.

The main job of a bank is to accept deposit and to give out a loan. The banks pay interest on the deposit money and also on the various saving schemes that it offers, like Fixed Deposit schemes. And the banks earn interest on the loans that it give. To run properly it should earn more than it gives as an interest, to cover for its operational cost and for other investments, like opening new branches, new ATMs etc.

The banks also borrow money from the Reserve Bank of India. And the interest that it pays to the RBI is called Repo Rate. See, it was not difficult to understand after all. This Repo rate is decided by RBI, and it is free to change it as and when it feels the rate warrant change. Over the years, this Repo Rate acts as a guiding rate for the banks to decide their lending rates, the interest rate that they charge on their loans.

blog-25-the-interest-rate

 

In the last financial year, RBI reduced Repo rate by 1.25% from 8% to 6.75%. Why it did that is an altogether different issue, and will be dealt with in another blog. But even after that Banks were very reluctant to reduce their interest rates. On an average, the banks reduced their interest rate by 0.6%. So it seems, even though they had the leeway they didn't pass on the complete benefit to the consumers. So are the Banks bad?

The answer is No. Here are a few reasons for them not passing on the complete benefit to the consumer:

1. Banks in India, have a very high Non-Performing Assets (NPA). NPAs are, in short, bank's loan gone bad, in which case the person or the company is not able to pay back the interest, leave alone the principle amount. Because of this banks profitability is suffering and so they didn't pass on the complete benefit of Repo Rate cut to the consumer.

2. The more the banks get a deposit the more money they have to give out as a loan to the consumer. However, for Fixed Deposit money, banks' have to compete with government saving schemes. Since these saving schemes, Public Provident Fund, KishanVikas Patra etc are government backed schemes so risk averse public is more likely to use these schemes. And to compete with them banks have to offer interest rate comparable to them.

3. When banks change the interest rate on loans, all the loan amounts get affected.

So even if a loan is sanctioned, in say 2006, when a bank reduces interest rate in 2014, that loan and another loan amount to be sanctioned after the decision, all are reduced. However, this is not the case with deposit rate. Change of rate in deposit rate is the only perspective. It means the reduction in deposit rate affect only the new deposit and not the old deposit.

So, all these three factors combined together resulted in less interest rate reduction last year. However things are looking up this year and the primary reasons are as follows:

blog-25-the-interest-rate-1

1. The economy, in general, is looking up, and so the NPA situation is bound to improve over the year, if not immediately. Some work done by the government in the road construction sector, DISCOMs, and steel sector will start showing result towards the end of the year and so banks situation is bound to improve.

2. The government has recently reduced the interest rate on all government saving schemes like PPF, KisanVikas Patra. This provides the opportunity to the banks to reduce the interest rate on their deposit schemes. This will lead to more money for banks which can then lead to a reduction in interest rate on loans.

3. RBI has recently framed a new policy for deciding on the base lending rate for banks, and this is also going to increase the rate of transmission of Repo rate cut on the lending rate. (More on this in another blog)

So overall, the situation looks good. The combined effect of Government and RBI has provided an ideal situation for the banks to start reducing interest rates. And we feel, we will see the effect very soon. This can, in general, be the start of Indian journey towards a low-interest rate regime.

The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of Fagnum.com. The writers are solely responsible for any claims arising out of the contents of this article.