RBI Credit Policy and impact on you and me

Well, Dr. Y V Reddy, the RBI Governor did what no one thought he would at this time, in increasing the Repo Rate by 50 basis points. He says to bring down inflation, he is willing to sacrifice growth in the short-term as his move will bring down (growth of) money supply as well as demand for credit.

Probably even before he finished saying "the cost of rice has gone up...so has the cost of dal...is not it necessary for the cost of money to go up to ensure balance", the decision makers in the banking community, the opportunists that they are, must have rubbed their hands in glee and let out, "Oh, yes...here we go...". Promptly they come on business channels and said, PLR will have to be revised. What they did not say was "Oh, yes...Now I can

While all this is may be by the book - if my purchasing costs (cost of raising funds) go up my selling price (lending rates) would have to go up, what beats me is this.

If the idea of the RBI intervention is to bring down rate of growth in credit (which is due to fresh demand), why should it in anyway affect existing loan-book. If the banking system has already disbursed say 1000 Crores as loans - it implies it has raised its resources in the past and the cost of the same is known to it and it has been factored into the price of the loan. Rate revision by RBI should in effect be neutral on what the bank has already spent (while raising funds before disbursal) or agreed to spend.

Let us put in Reddy-speak...say the bank has given me Rs.250 to buy 5 Kgs of Rice and 5 Kgs of Dal. I had agreed to pay back the bank Rs.25 every month for 12 months - works out to 20% p.a. in simple terms. Now the bank has made me a one-time disbursal - to make that, let us presume the bank had borrowed from RBI (or other sources at LIBOR+ etc) at say 12% p.a. In simple terms, bank has locked in an 8% Net interest margin. In real terms, it would be higher because my payments to the bank are in monthly installments - meaning if it wants to, the bank can repay to its lender every month the money it recovers from me and bring-down its outstanding liability.

In such a case, if RBI says henceforth its lending rate is going to be 15% p.a. (from earlier 12%), it is reasonable to expect that it applies to future borrowings of the bank from RBI. The bank is in no need to fund its 'previously fully disbursed loan to me' with new borrowings. Is it? So why does the bank feel compelled to raise interest rate applicable to me from to 25% (from earlier 20%)? In my view, not only is this practice unjustified it is always disproportionate.

While the tweaking of CRR will sure have an impact on the 'directly attributable cost' of already disbursed loans - If RBI assigns a higher risk weightage for loans given for purchase of rice and dal as in my example, then the Bank has to set aside higher amount of cash aside - unless the bank decides to pass on effect of CRR hike to future loans, it would be working in cross-purposes with what RBI intended.

By recovering more money from me each month the bank is able to fund its CRR requirements while keeping its existing cash available for new disbursals. Add to this the effect of disproportionate increase in rate. Where has the money supply for credit come down, which is what RBI intended to do in the first place. With supply side of money protected and remaining more or less static, the bank lends that to 'desperately-starved-for-cash' cases at higher rates. Makes more money (higher interest margin). Generates more money to lend...And laughs all the way to itselves :-)

Till RBI wakes up to this kind of opportunism (scam anyone?), people like you and me who take loans on 'floating rate of interest' just as the interest rate trend starts moving upward, would only suffer. Some would default. Some would go broke. Quality of assets on bank's books would start turning bad - meaning more NPAs on the books of banks.

RBI must ensure any CRR or Repo rate interventions have prospective effect - on fresh loans / advances / credit disbursals and not on existing loans / advances. In the name of 'choice in the hands of retail loan-seeker in going for floating or fixed rate loans', unsophisticated typically middle-class first-time home-buyers / asset buyers end up getting smooth-talked into availing floating rate loans.

What do you think?