Why are the Indian banking stocks under so much pressure?

Over the last couple of days, banking stocks have been under considerable pressure on the NSE and the BSE. The obvious reasons were always there. Credit off-take was languid, NPA is a major problem, PSU banks are suffering on efficiency metrics etc. But the real issue was an innocuous announcement made by the RBI a few days ago. Let us first understand the implications of this notification by RBI and why it is so important…

What is this RBI notification on base rates all about?

On September 1st, the RBI issued a notification to bring about uniformity in the calculation of base rates by banks. The RBI has suggested using marginal cost of funds as the guiding data point to set base rates for borrowers. Typically, there is no uniform formula adopted by banks to decide on the base rates although it is linked to the repo rates that the RBI announces from time to time. Most banks use the average cost of funds to determine the base rate for lending. This base rate, as the name suggests, acts as the base. Subsequently, depending on the purpose of the loan and the quality of the borrower the spread is decided.

Under the new notification, the RBI has suggested using the marginal cost of funds rather than the average cost of funds to decide on the base rate. Of course one needs to remember that this will be effective only April 01, 2016, so banks have this entire financial year to prepare themselves for the eventuality.

Why is this definition so important?

The banks are at an advantage when they use average cost of funds as a criterion for base rates. Let us understand with an example. Suppose the RBI cuts repo rates from 7.25% to 7%. If the bank has an average cost of funds that is higher, then it will not able to pass on the entire rate cut to the end customer. For example, since January 2015, the RBI has cut repo rates by 75 basis points in 3 tranches. However, banks have only passed on 30 basis points out of this as a rate reduction to the end customers on an average. The argument of banks has been that their average cost of funds is much higher, so effectively new borrowers are also required in the higher cost of funds of banks. By pricing the base rate on the marginal cost of funds, this anomaly will be eliminated and whatever rate cuts the RBI effects, will have to be immediately transmitted to the end customers.

Why are banking stocks getting hit because of that…

Well the answer is quite simple. When banks do not transmit the entire rate cut to the end customer, the bank benefits to the extent such cuts are not passed on. According to preliminary estimates, by shifting from the average cost of funds formula to the marginal cost of funds formula, banks will incur a total loss of Rs.20,000 crore. For banks that are already under stress, this could be quite a huge hit and that probably explains why the pressure on banking stocks has been so acute over the last few days since this new formula was announced.

Over the last few months, the RBI has expressed its reservations about the banks not passing on the benefits of rate cuts in its entirety to the end customer. The RBI has been of the opinion that this was largely impacting credit off-take and was also making the monetary loosening policy of the RBI less effective. While some of the banks had cut rates in response to the RBI guidance, it was still only about 35-40% of the cuts implemented by the RBI. By shifting to the new formula of marginal cost of funds for base rates, it will ensure that any repo rate cuts by the RBI are seamlessly and directly passed on to the end customer. In the short run, this decision may be negative for banking stocks due to the lower profits that they will be able to show. However, in the longer run this formula can spur the RBI to be more aggressive on rate cuts and improve credit off-take in the process. If that happens, banks will have a lot of future growth to look forward to. That is not a bad deal, after all!

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