Impact of Rate cut on existing home loan, RBI Rate cut impact

On April 17, 2012 RBI cut Repo Rate by 50 basis point (1 Basis point = 0.01%) i.e. by 0.50%. The new Repo rate effective Apr 17, 2012 is 8%…In layman term Repo (Repurchase) Rate is the rate at which the RBI lends money to the banks therefore now banks can get fund from RBI @ 8% interest i.e. 0.5% cheaper than before. What it implies is that Banks can now borrow the money for cheap & therefore logically should lend at cheap rates.

Let me explain how this cycle work, Banks monetary reserves are build through various deposit channels like deposits in Savings Account, Current Accounts, FD’s, RD’s, Bonds etc etc. Banks also borrow money from RBI @ Repo Rate which is now cut by 0.5%. Therefore in a nutshell Banks pay interest on deposits (except current account) it mobilized & pay interest on money they borrow from RBI or through other channels. After mobilizing funds through deposits and borrowing, Banks calculate Average Cost of Borrowing i.e. If bank has generated reserves of 100 Crores from deposits & borrowings and on an average basis, bank is paying interest of 7 Crore to all depositors then Average cost of borrowing for bank is 7% p.a. The Base Rate of Banks is linked to Average Cost of Borrowing and Banks can’t lend below Base Rate as per RBI directive. All the floating loans are linked to Base Rate.

In order to raise money cheap, banks always focus to increase their CASA ratio which is nothing but contribution of Current & Savings Account deposits in bank’s total deposits…Higher the CASA Ratio, Lower the Average Cost of Borrowing & Higher the bank margins…Current and Savings Accounts are cheapest source of fund becoz Bank does not pay any interest on Current Account and just 4% interest on Savings Account.

Now you must be wondering what the banks do with this money, Simple they lend this money through Loans like Home Loan, Auto Loan, Personal Loan etc…The interest charged for various loan types depend on risk attached to particular loan type…Most risky one are personal loans and most secured one is Home Loan.

Second question coming to ur mind must be, how banks fix interest rates for these loans…Answer is, it’s based on Average Cost of Borrowing + Bank Margins…Banks charge X% margin as their profit after adjusting Cost of operation & lend to Customers at Average Cost of Borrowing + X%…In above e.g. Average cost of Borrowing is 7% & assume banks keep margin of 2% then ideally banks should lend at 9% to customers for most secured loans like Home Loans. In idealistic scenario Average cost of borrowing never exceeds Repo Rate i.e. Rate at which RBI lends to Banks.

With this background, now when RBI reduced Repo Rate by 0.5% then just for window dressing most of the banks reduced their Base Rate from 0.10% to 0.25% whereas it should have been reduced by 0.5%.

The biggest Surprise or real Shocker comes from biggest lender State Bank of India, which decided not to reduce Base Rate which governs Home Loan Rates whereas SBI was proactive in reducing deposit rates on FD’s & reducing interest rates on Auto Loan. My simple question is after Repo rate is reduced, SBI also reduced interest rate on deposits then obviously & without any doubt the Average Cost of Borrowing will come down. When Average Cost of Borrowing has come down then why SBI is not reducing Base Rate? How come bank can lend at cheaper rate for Auto Loans but not for Home Loans, which are more secured? It directly implies that SBI is more interested to increase its profits rather following transparent approach. If bank is not reducing Base Rate then, why deposit rates are cut down proactively?

My question to RBI is what’s the use of introducing Base Rate? it was introduced to bring more transparency in system for fixing interest rates linked to cost of borrowing and was originally conceived to link the Base Rate with RBI Monetary policy i.e. When source of funds become cheap then banks should lend at cheap rate & vice versa but the end objective is not met becoz now banks are proactive in increasing Base Rate when RBI increase Repo Rate whereas reverse is not true. Can RBI force banks to reduce Base Rate? Answer is No, on papers RBI regulate banks but in actual Banks are formulating their own rules and regulations & defying the basic parameters of transparency therefore even after reducing Deposit rates & 0.5% drop in Repo Rate, SBI has not reduced Base Rate & others have reduced only between 0.10%-0.5% which is called window dressing. This is the reason why RBI is king without kingdom.

The answer of these questions is very simple, Home Loan is biggest and most profitable portfolio for all the banks..If SBI will reduce the Base Rate then by default Home Loan Rate of all existing customers will be reduced therefore will directly impact bank’s profitability. The scapegoat is Existing Home Loan Customers. Banks/HFC’s can lower Loan Rates for new customers by decreasing Mark up on Base Rate or increasing discounts on BPLR but Existing Home Loan Customers can’t do anything about this besides paying high EMI’s. Banks are only keen to acquire new customers by luring them with low interest and not at all interested to listen to existing Home Loan Customers.

Though on papers Govt. has given a status of Priority Landing sector to Real Estate but it is grappled with lot of problems majorly related to transparency which should be addressed immediately.

In continuation of this article, in my next blog I will highlight the step motherly treatment given to existing Home Loan Customers by Banks.