How Banks Will Manage Interest Rate Risk Once Loans Are Linked To An External Benchmark

The Reserve Bank of India’s guidelines, asking banks to link all new floating rate retail and micro and small enterprise loan products to an external benchmark rate from Oct. 1, will present lenders with a new set of challenges.

The new rules will mean that banks will see roughly 25 percent of their loan book linked to an external benchmark. However, their deposit base continues to be based on fixed rates.

This could leave banks exposed to interest rate risks as a change in lending rates may not be matched by a change in deposit rates.

“There is a mismatch because the frequency with which the assets will get repriced will likely be higher than the frequency at which liabilities will get repriced,” said Anil Gupta, vice president for financial sector ratings at ICRA Ltd.

Introducing Floating Rate Deposits

One option for banks is to introduce floating rate deposits.

In particular, banks can move to an external benchmark linked rate for bulk deposits above a certain amount. According to a report from SBI Economic Research, about 25 percent of the deposit base of banks is in the form of bulk deposits. These deposits are typically parked with banks by corporates.

PK Gupta, managing director of State Bank of India, told BloombergQuint that floating rate bulk deposits are an option. The concern is that the bank which introduces this new structure could lose out, unless all banks start linking interest rates on bulk deposits to an external benchmark. “There are lots of options but in our experience just one bank doing it doesn’t work. The whole ecosystem has to do develop it and if there are regulatory guidelines it helps,” Gupta said.

He added that a floating rate for small savers does not make sense but can be considered for bulk deposits above a certain limit. This would help banks transmit rate changes on the asset and liability side of their balance sheet.

Using Interest Rate Derivatives To Hedge Risk

Given the premium that banks attach to garnering deposits, a more likely option is that banks will need to start using interest rate derivative products to hedge their risk. To do this, lenders can use either Interest Rate Futures or the Overnight Index Swap markets.

Both come with their own set of problems.

The interest rate future market in India has remained relatively shallow despite many regulatory attempts to push up volumes. As such, any large hedging requirement cannot be supported given the current market volumes.

The OIS market seems like a more likely option that can be used for hedging.

Under an standard interest-rate swap contract, a bank can offer the buyer a floating rate and in return it will receive a fixed rate of return or vice versa.

For example:

• Bank A has Rs 100 crore worth of loans linked to the RBI policy repo rate
• On January 1, 2019, Bank A and Bank B enter into a 5-year interest rate swap
• Bank A agrees to pay Bank B a floating rate, say MIBOR + 2 percent, annually
• Bank B agrees to pay Bank A a fixed rate, of 8 percent annually

While, in theory, banks can use this route to hedge their risk, many practical issues remain.

Inadequate liquidity in the market is one of them. A senior risk officer at a private bank, who spoke on the condition of anonymity, said that there is lack of liquidity in the swaps market for these external benchmarks.

Another question is who will be the counter-party undertaking this trade with banks. If all banks are on one side of the hedging contract, who will provide the cover on the other side, asked Gupta of State Bank of India.

Even if there is a growth in the number of swap contracts, the market will be entirely on one side without any takers on the other side, said a treasury official at a foreign bank quoted above.

The official, speaking on condition of anonymity, added that there are not enough counter-parties and they may get inadequate return on their hedge.

Deepak Shenoy, chief executive officer of CapitalMind, disagrees. He believes that there would be enough takers for these swap contracts. There are banks, foreign banks in particular, that specialise in this area and trade these contracts frequently.

“Swaps are very liquid so if a bank wanted it could get a buyer. Banks are actually more worried about the mark-to-market impact on their assets-side, as they will have to pay a MTM fee on one part of the balance-sheet without getting the MTM profit on the other side,” he said.

When The Tide Turns

While banks may be at the losing end when interest rates are declining, they may stand to benefit when rates are on the rise.

In that scenario, loans will get priced higher sooner than deposits and banks will potentially see an increase in margins.

When interest rates start moving upward, a lot of money moves from savings accounts to term deposits as depositors want to lock-in their savings at a higher (fixed) rate, said Gupta. This creates some room for banks to mobilise more deposits when interest rates are rising, although customers would prefer fixed rates compared to floating rates, he said. In contrast, should banks start offering floating rates on deposits, then any upside would be limited as deposits and loans would get repriced together.

From the borrowers’ perspective, the likelihood of rate hikes over the medium term appears to be higher than rate cuts, Gupta said.