Excess liquidity and pricing of credit risk: Are we doing enough?

In the aftermath of the pandemic, the RBI has been at the forefront of stabilizing the financial system in terms of keeping liquidity in surplus mode. The average net durable liquidity injected into the banking system since April 21 is at Rs 9.3 lakh crore. The conundrum of weak credit demand and excess liquidity is evident from the average reverse repo at Rs 7 lakh crore since April and Government of India cash balances with RBI at Rs 3.4 lakh crore. Not surprisingly, the SBI Financial Stability Index reflecting all the surplus liquidity and credit spreads were at the highest level in August 21 since April 20.

Credit risk getting adequately reflected in pricing?

The SBI report stated that it is now pertinent to ask whether the credit risk is getting adequately reflected in pricing? A back of envelope estimate suggests that the core funding cost of the banking system that includes cost of deposits, negative carry on SLR and CRR and Return on Assets is currently at 6%, while the reverse repo rate is at 3.35%. Additionally, if the cost of provisions are added to the core funding cost, the total cost comes to around 12%. Clearly, banks are facing significant margin pressures.

This apart, market sources point out that risk premia over and above core funding cost are not fairly acknowledging the inherent credit risk. For example, 15 years loans are being priced at even lower than 6%, linking with Repo / T-Bill rates. It is to be noted that 10-Yr GSec is currently trading at 6.2% and by the current pricing trends this could even gravitate towards 6.0% again. This anomaly not only negates the concept of Tenor Premium but may create a material risk with regards to sustainability of such rates in long term, on which borrowers and banks are basing their financial calculations. The only good thing is that such pricing war is mostly restricted to AAA borrowers. 3 year term loans are being quoted at close to 4% repo rate and 7 year term loans for borrowers below AAA are also quoting a risk premium of 15-20 basis points over the 10 year rates. Working Capital Loans (WCL) are currently being quoted at a notch above reverse repo rate at 3.35%.

RBI’s nudge to borrowers

Interestingly, RBI had proposed the concept of normally permitted lending limit (NPLL) for the specified borrower, meant to nudge the borrowers to move towards the corporate bonds market, which may lose its importance. In the current situation, corporate bond rate and bank lending rate are showing huge differential.

The CP market is also witnessing significant churn with banks now almost absent. Non-Banking participants like Mutual Funds who do not have access to the RBI Reverse Repo window are creating pricing pressure in CP market as they are sometimes quoting below RBI reverse repo rate. In fact, the CP market reflects the huge pricing gap between better and lower-rated borrowers.

It is noteworthy that the industry is replacing its long-term debts with very low-priced CP / WCDL and this will obviously act as an enabler once the investment cycle revives. However, there is the risk of an Asset Liability mismatch if the liquidity is withdrawn quickly. As of now, the inflation numbers may not warrant such a decision from RBI, but if core inflation persists in the current range of 6% or above, that might act as a hindrance to continued liquidity abundance. As of now, low-interest-rate regime and low corporate taxes for corporates (taxes were cut in FY20) apart from expenditure reduction also contributed to large share buy-backs, with the 5 year period ended Aug’21 showing such buybacks at Rs 1.73 lakh crore. In the last 3 years, the share buybacks have been around Rs 65,421 crore.

The RBI has been navigating through the pandemic with a delicate balance. The SBI report has pointed out the period of extended surplus liquidity is already witnessing fierce pricing wars across banks, some of which may not reflect credit risk adequately. Perhaps the balancing act is most prominent when it comes in understanding the depositors’ and lenders’ interests. It estimates the total number of depositors in the banking system is around 207 crore, the number of creditors is at 27 crore. The total bank deposits at Rs 151 lakh crore constitute Rs 102 lakh crore of retail deposits, including that of senior citizens. Clearly, the real rate of return on bank deposits has been negative for a sizeable period of time and with RBI making it abundantly clear that supporting growth is the primary goal, the low banking rate of interest is unlikely to make a northbound movement anytime soon as liquidity continues to be plentiful. This implies that the current bull run in financial markets is possibly a break from the past as households may have got into the bandwagon of self-fulfilling prophecy of a decent return on their investment.

Way ahead

The report states it is now the opportune time to revisit the taxation of interest on bank deposits, or at least increasing the threshold of exemption for senior citizens. The RBI can also relook at the regulation that does not allow interest rates of bank to be determined as per age-wise demographics. Additionally, while there is no restriction by RBI on benchmarking of loans (as against earlier MCLR) and Banks are free to use any benchmark published by FBIL, continued restrictions on not allowing negative spread on MCLR may also be removed. This will help banks to be nimble, optimally manage and book quality business without having to expose the entire book to external benchmarks.