Credit risk

Excess liquidity and pricing of credit risk. 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 9.3 lakh crore. However, excess liquidity creates credit risk for financial institutions, according to a research note.

In the report, Dr Soumya Kanti Ghosh, Group Chief Economic Advisor of the State Bank of India (SBI), said: “The problem of weak credit demand and excess liquidity is evident from after repo average at Rs7 lakh crore since April and Union government cash balances with RBI at Rs3.4 lakh crore. Not surprisingly, the SBI Financial Stability Index reflecting all excess liquidity and credit spreads was at its 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 from the back of the envelope suggests that the core funding cost of the banking system which includes the cost of deposits, the statutory negative carry forward liquidity ratio (SLR) and the cash reserve ratio (CRR) and the return on assets (RoA) is currently 6%, while the repo rate is 3.35%. Moreover, if we add the cost of provisions to the cost of core funding, the total cost s “amounts to about 12%. Obviously, banks are facing significant pressure on margins,” Dr Ghosh added.

That aside, market sources told SBI that risk premia above the cost of core funding do not reasonably recognize the inherent credit risk. For example, he says, 15-year loans are charged at a price still below 6%, which is tied to reverse repo (T) bill rates. It is worth noting that 10-year government securities (G-Sec) are currently trading at 6.2%, and based on current price trends, that could even gravitate towards 6.0% again.

“This anomaly not only negates the concept of tenor premium but can create a significant risk as to the sustainability of such long-term rates, on 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 cite a risk premium of 15-20 basis points (points base) compared to 10-year rates. Working Capital Loans (WCLs) are currently listed one notch above the reverse repo rate at 3.35%.

Interestingly, the RBI had proposed the concept of a Normally Authorized Loan Limit (NPLL) for the specified borrower, intended to push borrowers into the corporate bond market, which could lose money. his importance. In the current situation, the corporate bond rate and the bank loan rate have a huge differential.

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

“It should be noted that the industry is replacing its long-term debt with very low cost credit or an on-demand working capital loan (WCDL), and this will obviously act as a catalyst once the cycle is over. investment will resume. However, there is a risk of an asset-liability asymmetry if liquidity is withdrawn quickly, ”the report stresses.

SBI believes that inflation figures may not justify such a move by RBI; but if core inflation persists in the current range of 6% or more, this could be an obstacle to continued liquidity abundance. Currently, a low interest rate regime and low corporate tax rate for businesses (taxes were reduced in fiscal years 2019-2020), in addition to spending cuts, have also contributed to major share buybacks, the five years ending in August 2021 showing such buybacks. at Rs1.73 lakh crore. Over the past three years, share buybacks have been around Rs65,421 crore.

RBI has gone through the pandemic with a delicate balance. However, according to the SBI, as it pointed out, the period of abundant excess liquidity is already the scene of fierce price wars between banks, some of which may not properly reflect credit risk. Balance is perhaps most important when it comes to understanding the best interests of depositors and lenders, he says.

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

It is clear, he says, that the real rate of return on bank deposits has been negative for quite a long time, and with the RBI making it clear that sustaining growth is the primary goal, the low rate is unlikely. bank interest rate moves north at all times. as soon as liquidity continues to be abundant. This implies that the current uptrend in financial markets may be a break from the past, as households may have entered the train of self-fulfilling prophecy of a decent return on their investment, he said. added.

“We therefore believe that the time has come to review the taxation of interest on bank deposits, or at least to increase the exemption threshold for seniors,” said the SBI, adding: “The RBI may also review the regulation that does not allow bank interest rates to be determined on the basis of age demographics. ”

Further, although there are no restrictions by the RBI on benchmarking loans against the previous marginal cost of funds (MCLR) based lending rate and banks are free to use n Any benchmark published by Financial Benchmarks India Pvt Ltd (FBIL), restrictions allowing negative spread on MCLR can also be removed.

According to SBI, this will help banks be nimble, run optimally, and record quality business without having to expose the entire book to external references.


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