RBI Fiat On Base Rate Will Destroy SOE Banks

The RBI just released draft guidelines on base rates, to be effective from April 1, 2016, once the guidelines are finalized. Until now, banks could set their base rate (minimum lending rate) after determining a spread over their total costs, factoring in operating costs, cost of funds and the minimum return on equity they deem adequate. The key is that banks had the option of using either the average cost of funds or the marginal cost of funds. As per the draft guidelines, banks will have to use the marginal cost of funds as the key input. 

They can still adjust for the negative carry of SLR and CRR and also add unallocable costs and determine their spread based on the minimum RoE that banks need to earn.  Rate cuts amidst volatility with new rules and competition  We think that, in a falling rate environment, the new “base-rate” formula may push banks to lower rates more than earlier, especially banks that have high base rates and were using average cost of funds. The average cost of funds is sticky and will take time to fall, while the marginal cost of funds is likely to fall more quickly, as banks cut deposit rates. It may force banks to cut rates more sharply, which appears to be a key objective of the RBI.  It could, however, make base rates much more volatile! 

Further, the 35bps base-rate cut yesterday by HDFC Bank is also likely to push banks to consider faster rate cuts.  +75bps cut in FY16; Low CASA; high floating-loan banks hit Given the low loan growth and incremental LDR <35%, we expect banks to begin cutting both deposit and lending rates. We reiterate our view that banks are likely to cut by at least 75bps and could even hit 100bps in FY16, especially if the RBI cuts rates.  Given the “negative” ALM mismatch that Indian banks run, their margins compress when banks cut deposit and lending rates. Banks with a low share of CASA and a higher share of “base rate”-linked loans may be impacted more. 

 HDFC Bk; ICICI Bk may see less hit; Govt. banks maximum hit  HDFC Bank, having just 20-25% “base rate- linked loans and +40% CASA is likely to see minimal margin pressure. ICICI Bank, too, could see less margin compression, owing to its much faster growth of domestic loans vs. overseas (on which margins are half). Govt. banks, in contrast, could see a much greater impact on margins. Hence, we may see more limited rate cuts by them, as their funding costs are also likely to be higher (owing to unallocable costs). SBI may be relatively better positioned owing to its high CASA.   Fillip to retail loans; Greater market share shift 

Retail loans may get a fillip from rate cuts, being the most sensitive to rates. Private banks, with a ~34% share of the retail loan market, are likely to be the key beneficiaries of rate cuts, especially the larger ones that have the lower base rates and a more dominant share of the retail market. Govt. banks may be more challenged, given their inability to match the sharply lower base rates that may prevail and their lower share of retail loans. SBI is likely to be the only real contender. It may continue to accelerate market share shifts that are already underway in favor of private banks