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  • Writer's pictureAbhijit Shankaran

Should Banks pass on High-Interest rates to their customers?

The debate over whether banks should pass on the benefits of interest rate changes to customers takes on a new dimension in the Indian financial landscape, posing a fundamental question about how banks should treat their customers when interest rates fluctuate. This predicament is centred on the decision to pass on the benefits of lower interest rates to borrowers, thereby making borrowing more appealing for investments and purchases. In this investigation, we focus on three key stakeholders whose complex interplay shapes the country's monetary policies, particularly interest rates in the context of the Indian Banking sector.

  1. The Reserve Bank of India (RBI),

  2. Commercial banks, and

  3. Bank Customers

Table of Contents

The Traditional Scenario: Interest Rate Dynamics

In traditional banking, interest rates are influenced by a complex web of variables, inclusive but not limited to the below

  1. The monetary policies of the central bank,

  2. Market supply and demand, and the

  3. The internal financial health of the banks

These rates vary according to a variety of factors, again including but not limited to

  1. Central Bank's (RBI) Monetary Policy

  2. Economic growth of the country (GDP Levels)

  3. Inflation Levels

Commercial banks frequently adjust their benchmark rates in response to changes made by central banks like the Reserve Bank of India (RBI), which has an impact on the interest rates that are offered to consumers.

With banks adjusting their rates in accordance with central bank policies and broader economic conditions, this traditional model has long served as the cornerstone of banking operations. Striking a balance between business success and ensuring accessibility and affordability for customers has always been the objective.

A depiction of the relationship between RBI, Banks and Customers in Indian Banking
The connection between RBI, banks, and customers

Economic Growth and Investment: The RBI's Role

The potential for economic growth and increased investment is a compelling argument for Indian banks passing on interest rate benefits to customers. Borrowing costs change when interest rates are adjusted, influencing individual consumers and businesses to seek loans for a variety of purposes, ranging from purchasing real estate to expanding their businesses.

In this regard, the RBI (Reserve Bank of India) plays a crucial role in managing important economic indicators like inflation, GDP, and GDP per capita. Specific to inflation, the most recent data available indicate that the estimated inflation rate for FY24 is 5.4%. The RBI cited this estimate in light of fluctuating food and energy prices around the world. For the purchasing power of the average person, stable inflation rates are essential.

Furthermore, the RBI closely monitors GDP, a measure of the country's economic output, and GDP per capita, which reflects the population's standard of living and economic well-being. Both of these metrics are important components of the RBI's monetary policy framework.

Adjusting rates such as the repo rate, bank rate, base rate, and others is a broad approach aimed at taking into account the well-being of all businesses, sectors, and the nation's overall economic health. When the RBI takes such actions, it hopes to stimulate economic activity, support India's economic growth, and improve citizens' financial well-being.

In the context of this article, we shall deep dive into one of the instruments, the Repo rate in the next section.

The Repo Rate: A Key Lever of Monetary Policy

At the core of the RBI's strategy is the repo rate, a financial instrument that signifies the rate at which the RBI lends money to commercial banks. This instrument, in essence, embodies the central bank's approach to managing liquidity in the banking system and influencing interest rates.

The repo rate, intricately tied to the free market dynamics, serves as a linchpin in the relationship between the RBI and commercial banks. When the RBI decreases the repo rate, it makes it more affordable for banks to borrow funds from them, thereby reducing their cost of capital. In response, banks may consider passing on the benefits of lower borrowing costs to customers by offering competitive interest rates on loans. This interplay between the repo rate, the free market, and banking practices is a dynamic mechanism, with far-reaching consequences.

Consumer Behavior in the Face of Repo Rate Changes

Surprisingly, even when the RBI sets relatively high repo rates, customers continue to seek loans. As of June 2023, the repo rate stands at 6.50%, a significant figure. In the same period, FY23 data states that vehicle loans have witnessed an increase of 23.4%, home loans have risen by 15%, and education loans have surged by 16%. These statistics highlight the resilience and adaptability of consumers in the face of changing economic conditions.

Nevertheless, there are challenges associated with repo rate changes. When the RBI opts to increase the repo rate, banks often feel compelled to pass on the rate hike to customers. While this approach aligns with sound financial practices and risk management, it can lead to struggles for customers who find it difficult to repay loans.

The Banking Sector Dilemma: Numbers Speak

The banking sector faces several challenges when deciding whether to pass on interest rate benefits to Indian customers. This decision has an impact on the customers as well as the sourcing bank's bottom line. Here, proper price equilibrium is vital to ensure that both parties' interests are taken into account.

For instance, Base rate and spread rate mechanisms are used by banks when issuing home loans to customers, as set forth by the RBI. Any decrease in the base rate has the potential to lower the overall interest rate. The question of whether it's possible to switch to floating rates when the market is favourable arises in the case of fixed-rate loans, though.

It's crucial for banks to review their rate mechanisms frequently, at least once a year, to maintain fairness and adaptability. This guarantees that the rates are reasonable and in line with the shifting financial environment. This further affects loan offerings in terms of Fixed and Floating rates which is discussed in the succeeding section.

Fixed Rate and Floating Rate: Finding the Right Balance

In terms of loan offerings, Loans fall into two important categories: Fixed-rate and Floating-rate loans. Fixed-rate loans have the advantage of consistent and dependable monthly payments, which make it simpler for borrowers to budget. However, borrowers with fixed-rate loans might lose out on potential savings when market interest rates fall. Fixed interest rates are usually set higher than floating interest rates because fixed rates cannot be changed once set. In the context of home loans, on average, fixed interest rates are marginally higher than floating interest rates.

The interest rates on floating-rate loans, however, can fluctuate depending on the state of the market, making them more dynamic. While this may result in lower interest costs when rates decline, it may also result in higher EMIs when rates increase. For both banks and borrowers, finding the ideal balance between fixed and floating rates is crucial.

Although the ratio of fixed to floating-rate loans is crucial for both banks and borrowers, the decisions made in this area have more ramifications than at first appears. The siren song of competitors' lower interest rates frequently lures borrowers. When you think the bank has a client for good, a fierce battle for market share breaks out! Many banks can take advantage of changing market interest rates to offer customers more alluring terms, luring them to switch. However, this choice conceals unforeseen expenses, such as foreclosure fees, which quickly devour any perceived gains. When a borrower pays off the loan before the agreed-upon term, foreclosure fees are imposed, and these fees have a big impact on how cost-effective switching banks are. As borrowers complete the procedures to transfer their loans, processing fees might also build up.

By giving borrowers the knowledge they need to evaluate the subtle advantages of strategies like Variable Monthly Installments (VMI). This approach combines elements of fixed and floating rates by fixing the loan tenure while allowing the EMI to vary. Banks can incentivize clients to commit to them even when they may be tempted to switch to another bank with a lower interest rate by providing VMIs. NACH management solutions can act as their financial fortress. Banks can utilize NACH management solutions to automate loan repayments, making it easier for borrowers to settle loans that were once—and frequently still are—managed using post-dated cheques (PDC). This automation improves the entire customer experience by streamlining the payment process and lowering the possibility of payment delays and errors.

In order to give their customers the best options and maintain their own financial stability, banks must traverse the challenging task of finding the ideal balance between fixed and floating rates.

The Competitive Landscape and Portfolio Diversification

Indian banks are caught between the legacy of traditional financial institutions and the disruptive force of FinTech startups. Traditional banks, which have long been pillars of India's financial sector, have provided various services, from savings accounts to mortgages. Furthermore, customers in India have historically placed a high level of trust in these well-established institutions. The rise of FinTech, on the other hand, has added a new dimension to competition, as these tech-savvy startups use digital platforms and innovative approaches to deliver financial products and services at unprecedented speed and convenience. This landscape presents a difficult paradox in which traditional banks must adapt and innovate to remain competitive in a market shaped by new-age disruptors in the early stages of establishing consumer trust.

To address these complexities, loan portfolio diversification plays a vital role by offering a broader range of customers while managing their own risk by offering various types of loans, such as personal loans, housing loans, and small business loans. Portfolio diversification is essential to counter threats aka volatility in financial terms. The more diversified the portfolio is, the lesser volatility prevails, making the portfolio that much more conducive for both banks and customers. Volatility in the context of a bank is non-repayment of loans and difficulty achieving their desired bottomline. Diversification is not only a risk management strategy, but it is also a way to improve consumers' standard of living. It enables people to access funds for a variety of purposes, such as purchasing a home, starting a business, or dealing with unexpected expenses, all of which contribute to a higher quality of life.

NPA, Loan Repayment and the Influence of Repo Rate

A Non-Performing Asset (NPA), is a financial asset that ceases to generate income for a lender, typically a bank, due to the borrower's inability to meet their loan repayment obligations. Non-performing assets (NPAs) are a major source of concern for banks. When customers do not repay their loans in time, the bank's profitability suffers, as does its ability to provide competitive interest rates. Banks favour borrowers that consistently fulfil their repayment schedules and would want to promote such responsible conduct by giving reduced interest rates in a healthy lending market.

However, if NPAs increase, banks may be forced to raise interest rates to manage the increased risk. This is not their primary goal, but rather a pragmatic response to the changing lending situation.

Drawing on an earlier section on repo rates, a rise in repo rates increases the borrowing costs for commercial banks, which results in banks passing on the interests to individuals. This makes it challenging to service existing loans and non-payment results in the rise of Non-performing assets which negatively impacts the bottomline of banks.

Even when applicants fulfil the initial loan conditions, the alarmingly high rate of non-repayment raises legitimate concerns about the loan criteria and the efficiency of underwriting procedures. It might be prudent for banks to review and modify their loan requirements, putting more weight on determining the borrower's capacity to pay back the loan over its term.

This can entail conducting more thorough background checks on a borrower's finances, examining their current financial obligations, and thoroughly verifying their income. The goal is to spot any warning signs that might eventually result in non-repayment. Having explored the blockers that arise from Non-repayment of loans, it is interesting to draw upon the latest figures put forth by the RBI. The net Non-Performing Assets ratio has drastically fallen from 11.8% as of 2018 to 3.9% as of March 2023. This is a testament to consistently implemented policies by the RBI suggesting that borrowers are repaying the loans relatively consistently in the last 5 years.

It is critical to recognize that maintaining this trend and closing the gap between NPAs and healthy assets will almost certainly necessitate creative thinking and out-of-the-box solutions.

While the Reserve Bank of India's (RBI) role in implementing effective policies is critical, both lenders and borrowers must remain committed to responsible financial practices. Achieving a sustainable reduction in NPAs requires not only policy but also a collaborative effort to maintain a healthy lending ecosystem.

Leveraging Financial Literacy for Competitive Rates

It is essential to emphasize that Indian customers have options when it comes to banks and loan products. Customers can benefit from comparing rates and terms in a highly competitive market to find the best fit for their financial needs. However, it is not only important to find the best deal; it is also important to understand how these financial decisions affect individual lives.

Financial education empowers consumers with concepts such as compound interest, debt management, and asset-liability distinctions. This knowledge enables them to make informed decisions, achieve stability, and strive for financial freedom while mastering money management and debt management strategies.

Many Indian customers have varying levels of disposable income, which is where financial literacy comes into play. Banks contribute to empowering individuals to make informed financial decisions that align with their income levels and future goals by making loan products accessible and ensuring customers understand the implications of interest rate changes on their loans and overall financial well-being.

The Disruptive Force: Banking Technology

The Digital revolution in the context of streamlining and optimizing supply chain finances using technology is much spoken about. Simply put in a nutshell, 'Digital Transformation' can pull banks out of the otherwise unfortunate business predicament of having a good turnover (top-line) but low profit after taxes (bottom-line). The focus on increasing bottomline efforts by tightening topline expenses using digital transformation is certainly one among the many controllables that banks can explore.

A new era in banking has begun with the development of banking technology, or "fintech." Every aspect of the industry is changing as a result of digital platforms, artificial intelligence, blockchain technology, and sophisticated algorithms. Interest rates are one of this transformation's most significant effects.

Role of Data Analytics in Decision-making

Financial institutions now have access to a previously inconceivable level of data analysis thanks to banking technology. Banks can now make more accurate and data-driven lending decisions thanks to advanced analytics. The risk associated with loans is decreased by these technologies' remarkable accuracy in determining an individual's creditworthiness. As a result, banks may have a more favourable risk profile and be able to charge customers lower interest rates.

Streamlining of workflow

Banking operations have been streamlined by automation and digitization. Automated procedures can reduce overhead expenses, which can result in cost savings and possibly enable banks to provide borrowers with competitive interest rates. These efficiencies may lead banks to pass on these savings to customers as the industry develops further.

New-age disruptors

The financial industry now faces a higher level of competition thanks to fintech startups. These tech-savvy disruptors frequently provide cutting-edge financial services and products at previously unheard-of speeds. Traditional banks must adapt to stay competitive in this constantly shifting environment. Banks are forced to offer competitive interest rates in order to draw and keep customers, giving customers more choices.

Conclusion: Banks Passing on Interest Rates. Yes or No?

The future of interest rates is poised for a significant transformation as banking technology develops further. Banks have the chance to improve their lending tactics, lower risk, and work more effectively. As a result, customers may benefit from competitive interest rates without having to wait for banks to pass along changes in benchmark rates in the financial ecosystem.

The question of whether banks should pass on the benefits of interest rate changes to customers is not straightforward. It's a complex subject that necessitates a balanced approach. Banks must provide competitive rates to borrowers while also ensuring their own financial health and promoting financial literacy. Whether it is a B2B or B2C model, the banking sector ultimately serves the population. As a result, it must adapt to the changing financial landscape and the changing needs of the average person. Finding the right balance benefits everyone, from customers to banks and the broader economy, in a world where interest rates affect nearly every financial decision we make.


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