Credit risk

Excess liquidity and credit risk pricing. Are we doing enough, asks SBI

In the aftermath of the pandemic, the Reserve Bank of India (RBI) has been at the forefront of stabilizing the financial system to keep liquidity in excess mode. The average net sustainable liquidity injected into the banking system since April 2021 is Rs9.3 lakh crore. However, excess liquidity creates credit risk for financial institutions, according to a research note.

In the report, Dr. Soumya Kanti Ghosh, Chief Economic Advisor of the State Bank of India (SBI) Group, says: “The problem of weak credit demand and excess liquidity is evident from the reverse average repo at Rs7 lakh crore since April and Union government cash balances with RBI at Rs3.4 lakh crore Unsurprisingly, the SBI Financial Stability Index reflecting all excess liquidity and credit spreads were at the highest level in August 2021 since April 2020.”

However, in this context, he says it is now relevant to ask whether credit risk is correctly reflected in pricing. “An estimate of the bottom of the envelope suggests that the basic funding cost of the banking system, which includes the cost of deposits, the negative statutory liquidity ratio (SLR) and the cash reserve ratio (CRR) and the yield of assets (RoA) is currently 6%, while the reverse repo rate is 3.35%, and if we add the cost of provisions to the base funding cost, the total cost rises around 12%. Clearly banks are facing significant margin pressures,” Dr Ghosh added.

That aside, market sources told SBI that risk premiums beyond the base funding cost do not reasonably account for inherent credit risk. For example, he says, 15-year loans are priced at even less than 6%, tied to repo and treasury (T) bond rates. It should be noted that 10-year government securities (G-Sec) are currently trading at 6.2%, and based on current price trends, this could even gravitate towards 6.0% again.

“This anomaly not only negates the tenor premium concept, but may create a significant risk to the sustainability of these long-term rates, upon which borrowers and banks base their financial calculations,” the report said.

The only good thing, according to SBI, is that such a price war is mostly limited to AAA borrowers. Three-year term loans are quoted at a repo rate close to 4%, and seven-year term loans for borrowers below AAA also quote a risk premium of 15 to 20 basis points. base (basis points) against 10-year rates. Working capital loans (WCL) are currently priced one notch above the reverse repo rate at 3.35%.

Interestingly, RBI had proposed the concept of a Normally Authorized Lending Limit (NPLL) for the specified borrower, intended to incentivize borrowers to move into the corporate bond market, which may decline in importance. In the current situation, the rate of corporate bonds and the rate of bank loans show a huge differential.

According to SBI, the commercial paper (CP) market is also experiencing significant turnover, with banks now almost absent. Non-bank participants like mutual funds, which do not have access to the RBI reverse repo window, create price pressure in the CP market as they sometimes quote below the repo rate reverse RBI. In fact, he says, the CP market reflects the huge price differential between the highest-rated and lowest-rated borrowers.

“It’s worth noting that the industry is replacing its long-term debt with CP or working capital demand loans (WCDLs) at very low prices, and this will obviously act as a catalyst once the investment cycle However, there is a risk of an asset-liability mismatch if liquidity is withdrawn quickly,” the report points out.

SBI believes that inflation figures may not justify such a move by RBI; but if underlying inflation persists in the current range of 6% or more, this could be an obstacle to maintaining the abundance of liquidity. Currently, a regime of low interest rates and low corporate taxes for businesses (taxes were reduced in FY 2019-20), in addition to spending cuts, have also helped to significant share buybacks, with the five years ending August 2021 showing such buybacks. at Rs1.73 lakh crore. Over the past three years, share buybacks have been around Rs65,421 crore.

RBI navigated through the pandemic with a delicate balance. However, SBI says, as it had pointed out, the period of abundant excess liquidity is already witnessing fierce price wars between banks, some of which may not reflect credit risk properly. Perhaps the balancing act is most important when it comes to understanding depositor and lender interest, he says.

According to the estimate of SBI, the total number of depositors in the banking system is around 207 crore, the number of creditors is 27 crore. Total bank deposits at Rs151 lakh crore constitutes Rs102 lakh crore of retail deposits including seniors.

Clearly, he said, the real rate of return on bank deposits has been negative for a long time, and with RBI making it very clear that supporting growth is the main objective, the low rate of return is unlikely to bank interest makes a move north at any time. as soon as liquidity continues to be abundant. This implies that the current bull run in financial markets may be a break from the past as households may have jumped on the bandwagon of the self-fulfilling prophecy of a decent return on their investment, he added. .

“We therefore believe that now is the time to review the taxation of interest on bank deposits, or at least increase the exemption threshold for senior citizens,” says SBI, adding, “The RBI may also review the regulations which does not allow bank interest rates to be determined by age demographics.”

Furthermore, while there are no restrictions by RBI on benchmarking loans against the previous marginal cost of funds (MCLR) lending rate and banks are free to use any index of benchmark published by Financial Benchmarks India Pvt Ltd (FBIL), the continued restrictions on not allowing negative spread on MCLR may also be removed.

According to SBI, this will help banks be nimble, manage optimally, and book quality deals without having to expose the whole book to external referrals.