Nudging banks towards a competitive scenario

With official policy forcing banks to be more competitive interesting times are ahead. The RBI Governor and the BOI Chairman discuss. By C. R. L. Narasimhan

Although not widely commented upon, the recent credit policy statement of the Reserve Bank of India seeks to further financial sector reform and spur competition among banks and other financial entities. A policy statement can only announce the setting up of new institutions or modify existing rules and regulations. How well they impact on the financial system remains to be seen. Take the competition aspect. Increased competition in the financial sector is what the credit policy aims at. Here, well thought out measures relating to the prime lending rates (PLRs) and flexibility in term deposits of banks are particularly relevant.

Shortly after the credit policy announcement this Correspondent spoke to the RBI Governor, Dr. Bimal Jalan, and the Bank of India Chairman and Managing Director, Mr. K. V. Krishnamurthy. Also on another highly important factor in the financial sector, the public ownership of banks. Does the fact of government ownership a very large part of commercial banking is still under government majority control - stifle competition? But first a look at the monetary and credit policy measures.

PLRs, first introduced in April 1997, have since been substantially rationalised and modified. Banks can now offer different types of PLR now - one based on the term lending rate, a tenor-linked one and so on. Until now, PLRs set the ceiling for loans up to Rs. 2 lakhs (banks cannot charge more for that category).

But for loans in excess of Rs. 2 lakhs, banks cannot charge less than their PLRs. In other words, PLRs set the minimum levels for interest rates on most loans.

Deeper meanings

In the latest credit policy statement, the RBI has decided to follow international practice and convert PLRs into benchmark rates rather than treat them as minimum lending rates. Banks can now offer their valued customers (the statement specifically mentions exporters also) loans at rates below their PLRs.

While in export credit, the interest rates have been mandated at 1.5 per cent below the PLR, other valuable borrowers can get such benefit only if the respective banks and their boards think so. This flexibility is what drives the banking system towards competition. Banks can now book relatively large deposits (Rs. 15 lakhs and above) as term deposits for a minimum period of one week instead of the earlier 15 days. Also, in certain cases they can refuse premature withdrawal of large deposits, provided they have informed their customers initially.

Dr. Jalan agreed with the view that the policy nudges banks and institutions towards competition. The idea is to usher in a system based on investor-saver choice based on competition. This may, however, take about five years to emerge. The RBI Governor's views on the future of PSBs are interesting. The Finance Minister has said the Government stake will eventually be brought down to a third but these banks will continue with their government character. That statement needed clarification as the stifling nature of public ownership is widely perceived to have affected the PSBs.

Dr. Jalan, however, felt otherwise. Provided banks follow the prudential norms, are well capitalised, have autonomy and have independent directors there is nothing wrong with retaining the government character (without majority stake), he said. It can be a viable model. ``Recent experiences suggest that the public trusts the public system more as investors and savers,'' he said adding that ``autonomy (for PSBs) does not run counter to minority ownership by government.'' Anyway, there are larger issues concerning public institutions, public service and public servants that have to be resolved. If ``the public are placed at the centre everything resolves itself,'' he said.

Margin squeeze

Mr. Krishnamurthy said that (after the recent credit policy) increased competition is on the anvil. BOI has already introduced a short-term PLR (now 10.5 per cent). It is able to invest surplus short-term funds more profitably than in CPs, CDs and so on. For the banking system, one of the greatest challenges will be in lending at below their prime rates. Especially so because the cost of funds is also going to increase.

Even though the SB interest rate has not been deregulated (it is at 4 per cent), banks will have to pay more because of the new relaxation permitting banks to accept deposits for even seven days. Hence, those having large sums in their SB or even (non- interest bearing) current account will shift to short-term deposits. All banks will then have to reckon with a much higher cost of funds. According to the BOI Chairman, the rate for a seven-day deposit will logically have to be above the SB rate, say at least 5 per cent. In actual practice major banks pay only 2.5 per cent on SB deposits (because of the way interest is calculated).

Hence there will be increased pressure on the margins of major banks and therefore on profitability. To bring the issue into clear focus, Mr. Krishnamurthy said that for a bank of BOI's size even a one per cent variation in PLR can increase or decrease profits by Rs. 60 to 70 crores. Without doubt there would be a significant increase in the cost of funds because of the new provisions. In that context, when banks start lending, because of competition, at below their prime rates there would be additional pressures on their margins. How many banks can withstand such erosion in margins? Especially when fixed costs are not going to decrease.

Over the medium term mergers between banks will become inevitable. Already some banks are slipping up on their capital adequacy. Therefore, they cannot lend more. In a scenario where margins are getting squeezed they can stay in the race only by increasing volumes. So unconventional measures such as leasing of unprofitable branches and consolidation are indicated. However, like the RBI Governor, the BOI Chairman holds the view that the public sector model but with increased efficiency and productivity will be relevant for India.

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