Will The Flood Of Deposits Bring Down Lending Rates?

In the first eight days after the withdrawal of Rs 500 and Rs 1000 notes from the system, banks have seen Rs 5.44 lakh crore in deposits flow into their coffers. About Rs 1.33 lakh crore has moved out in the form of withdrawals and in exchange for old currency notes.

That still leaves banks sitting on a huge pile of Rs 4.11 lakh crore in unanticipated deposits. This means a near doubling of the deposit base of scheduled commercial banks, which, as of November 11 had deposits of Rs 4.1 lakh crore.

Flush with funds, banks are paring rates on fixed deposits to slow down the inflow of money. This, however, may not necessarily translate into lower lending rates immediately, caution analysts who say that a chunk of these deposits will move out of the banking system as soon as restrictions on withdrawal of funds is lifted.

Wait And Watch

According to analysts, banks will wait and watch to see what proportion of the deposits stay within the banking sector. While the marginal cost of funds will come down for banks in the third quarter as low cost deposits surge, the drop in rates may not last for long if cash supply and withdrawals pick up.

Banks, post April 1, have started pegging their loans to the marginal cost of funds lending rate, or MCLR, as mandated by the Reserve Bank of India. This rate is reviewed on a monthly basis.

Since November 9, when the demonetisation decision was announced, several banks have cut deposit rates across tenors in the range of 10 basis points to a full percentage point. A basis point is one hundredth of a percentage point.

Large private players like ICICI Bank and HDFC Bank cut rates by 25 basis points while state-owned Union Bank of India cut its rates by up to 1 per cent for short term deposits. The country's largest lender State Bank of India cut its deposit rate by 15 basis points on one year fixed deposits to 6.90 percent, according to the bank's website.

Read: Banks Collect Rs 5.44 Lakh Crore So Far In Cash Clean-Up Exercise

This means that the cost of borrowing for banks will reduce, leading to the expectation that there will be a cut in lending rates as well.

“The flow that is coming to banks is purely in the form of current and savings, and some through loan repayments. What we've seen is that there have so far been some reductions in deposit rates in different buckets. This makes us believe that surely MCLR will go down from here. With this kind of flows coming in, your incremental cost of borrowing is coming down,” said Darpin Shah, associate vice president at HDFC Securities.

But, banks do not necessarily have to pass on the entire benefit in the next monthly review, Shah said.

Another factor that may delay lending rate cuts is the RBI's monetary policy review in the first week of December, where the central bank may cut its policy rate. Banks may choose to wait until after the review to decide on rates.

Shah says that rates should come down in the first quarter of calendar year 2017 once the volatility in deposit flows dies down.

This view is not unanimous.

Some analysts, like Jignesh Shial, vice president of research at Quant Broking said that lending rates could drop sooner than that. This is because credit growth is sluggish and banks will have to deploy the additional deposits.

“The cut in MCLR in the next review meeting of banks is likely to be sharper than what we've witnessed so far. Already a couple of banks have announced cuts,” said Nitin Aggarwal, an analyst at brokerage firm Antique Stock Broking.

Read: For Banks, A Slow Crawl Back To Normalcy

Impact On Margins

The cost of demonetisation for the banking system has not yet been estimated. Banks say it is too early to make projections, but the impact may be sizable.

While the logistics cost involved in exchanging the old currency with the new cannot be estimated, analysts expect that the huge inflow of money will have a bearing on spreads.

As a result, though there will definitely be a reduction in the cost of borrowing in terms of interest rate cuts, the overall cost of borrowing is going up very quickly leading to an asset-liability mismatch, said Shial.