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Falling Rate of Interest In The Banks:

Bank Spreads, Profitability Comes Under Pressure

Dr. R.K. Uppal1
The banking sector plays a crucial role in the economic development of a nation. An efficient, effective, vibrant and innovative
banking stimulates economic growth by mobilizing savings and efficiently allocating funds for productive purposes. Indian Banking industry
underwent repeated restricting and revitalization since nationalization. At present, in India, there are five major bank groups namely, SBI and
its associate banks, Nationalized banks, Old private sector banks, Foreign banks, and New private sector banks. They are playing a very
crucial role in the economic development of the country.
India's Economy covers a wide range of issues connected with monetary financial economics in a developing country like India,
in the context of globalization. Due to a steep fall in interest rates in the economy, the yield curve has moved down by 3%. This has reduced
the interest income and hence, the profits of the banks. The active management of the portfolio can improve the spreads. However, the yield
on advances can go down further and hit the profits, as we are not expecting any upward movement in the interest rate scenario in coming
years. Banks can reduce the deposit rates to improve the spreads, however, the banks can reduce the deposits rate up to a certain level.
Recently, all the banks have reduced the deposits rates but that is not sufficient. So, banks have to find ways to improve the spreads (Net
Interest Income).
What fundamental changes have resulted in lower interest rate scenario in the country :
The interest rate scenario in our country was a regulated structure for a fairly long time. In the last few years interest rates have
been deregulated. After the deregulation, interest rates initially moved up. However in recent times, interest rates have begun to come down,
mainly because of ample liquidity prevalent in the system. The integration of the domestic economy with global economies also had a
positive impact on the interest rates. When global interest rates witnessed a downward movement, a similar declining trend was also
observed in our interest rates, especially, over the last year. Upto last year, couple of rigidities existed in the interest rate structure, which
have since been rationalized in the current year's budget. In calendar, year 2001, interest rates across all small savings instruments like
PPF, Post office monthly income schemes, RBI relief bonds have been reduced. Thus the global developments, coupled with reduction in
the administered rate structure, lower inflation and ample liquidity have led to lower interest rates in our country.
As for the structure of interest rates, the RBI says, that, while there has been a significant softening of interest rates in the last 20
months, the decline in nominal interest rates has not kept pace with decline in the rate of inflation. This is because there are several
structural factors, which constrain downward flexibility in the interest rate structure in India.
Incidentally, now the prime lending rates of banks for commercial credit are entirely within the purview of the banks and are not
set by the Reserve Bank. The domestic interest rates which are subjected to regulate, are only the rate of interest on savings accounts and
interest rates on export credit and credit for small and tiny sector upto an amount of Rs. 2 lac. The key rates fixed by RBI, namely, the bank
rate, repo rate and the rate on savings account have already come down substantially to 7.00 percent, 5.00 per cent and 4.00 per cent
respectively. At these levels, the rates are not too out of line with ruling international rates.
However, the non-interest operating expenses of public sector banks in India are high by international standards. These work out
to 2.5 to 3 percent of total assets. The high transaction costs, which generally reflect high staff costs, combined with relatively high levels of
non-performance-assets, further constrain the maneuverability in respect of lending rates. To quote the RBI, following are some of the
factors which reduce downward flexibility in the rate of interest structure in India :
 Banks have been given the freedom to offer "Variable" interest rates on long-term deposits. However, for various reasons, the
preference of depositors as well as the traditional practice with banks tended to favour fixed interest rates on term deposits. This practice
has effectively reduced the flexibility, that banks have in lowering their lending rates in the short run, since the rates on the existing stock of
deposits cannot be lowered.
 For public sector banks, the average cost of funds is over 7.00 percent and for many private sector banks, the average cost is
even higher. The non-interest operating expenses generally work out to 2.5 to 3.0 percent of total assets, putting pressure on the required
spread over cost of funds. Relatively high overhang of non-performance-assets pushes up further, the lending rates.
 There is a persistent and large volume of market borrowing requirements of the government, giving an upward bias to the
interest rate structure.


 The recent reductions in deposit rates and return on small savings have caused widespread concern among depositors because
of lack of other risk-free avenues for financial savings. This constrains the ability of banks to effect further reduction in their lending rates
without affecting their deposit mobilization and the growth of financial savings over the medium-term.
 Very high liquidity in the system persists, which will further reduce the interest rates.
 The credit off take is inconsonant with that of deposits due to less demand for credit.
Who are the major beneficiaries and non-beneficiaries of the lower interest rate structure:
In India the biggest borrower is, the government of India whose interest liability amounts to 49% - 50% of the total budgeted
revenues. Therefore, it is imperative for the government of the India, to bring about fiscal consolidation and reduce interest burden. As a
result, the government is the primary beneficiary of cheaper borrowings. Corporate and development financial institutions are the other large
beneficiaries of lower interest rate structure. Poor class, particularly, middle class who needs cheaper credit may be more beneficial.
But adverse effect will be on those persons, who depend upon interest income, particularly, retired persons and even senior
citizens (although some extra facilities are given to the senior citizens). Much harmful effect may be felt by higher income group because
where this class will invest ? Normally, this class does not take much risk; they consider their money safer in banks than any other
investment or institution.
Downward trends in rate of interest and its overall effect on profitability of the Banks:
One of the popular analytical tools to determine the bank's profitability is, the ratio of net profit as percentage of working funds.
This ratio indicates the efficiency, with which, a bank deploys its total resources/working funds so as to maximize its profits. Thus, the ratio
serves as an index to the degree of asset utilization by banks.
Trend in the profitability of State Bank of India and its associate banks:
Bank-wise statistical analysis of the ratio of Net Profit as a percentage of working funds reveals maximum average ratio for State
Bank of Patiala (1.15 percent), State Bank of Bikaner and Jaipur (0.92 percent) and State Bank of Hyderabad (0.85 percent) and State Bank
of Indore (0.70 percent) respectively. In general, the profitability at the end of study period declined for all the banks in this group. Many
factors are responsible for this decline like high NPAs, declining spread, high burden, severe competition and recently declining rate of
interest is responsible for the declining profitability.
Trend in the Profitability of Nationalized banks :
Nationalized banks have showed almost similar results. At the end of the study period, the profitability declined for all the banks
accept Syndicate Bank and Vijay Bank. Overall, even in the declining period of rate of interest, the performance of PNB, OBC, and
Corporation Bank is quite satisfactory.
Main Issues :
Due to the fall in the interest rates in the banks, following issues arises.
 Interest margins is coming down, thereby, affecting profitability of the banks.
 There is negative impact on spread in the downward interest rate regime since liabilities attract fixed interest rate till maturity
where assets bear floating interest rates.
 NPAs mount up. Need for more provisioning, which may adversely affect the profitatbility.
 Banks unwilling to take higher risk, deploy funds in low return areas, reduces profitability.
Due to fall in interest rate and severe competition, it is very difficult for almost all the nationalized banks to increase their interest
income, the only option, which may be helpful for all the banks to increase other Income. The term other income refers to all non-interest
earnings of banks. However, three heads, namely commission, exchange and brokerage, exchange transaction, and sale of investment
account for over 85 percent of other income of banks. It however forms, hardly 15 percent of total income of banks. Hence, as compared to
interest income, banks' earning under this head is quantitatively, rather insignificant. It must be near about 30percent. Non-interest
expenditure must be reduced by various methods.
Spread (Net Interest Income) may be increased by :
 reducing the average cost of resources by consciously avoiding high cost Inter-bank deposits and high cost market borrowings.
 Better customer services should be provided.
 Better market strategies should be adopted.

 IT and Computerization should be adopted.
 Research-Oriented Programmes should be adopted.
As far as the burden (Non-Interest Expenditure, Non Interest-Income) is connected, it can be reduced by way of :
 Pricing all products/services/non-fun-based facilities based on the cost-benefit analysis.
 By observing strict cost control.
 VRS should continue, which will helpful to increase the computerization in banks and it will positively effect, the productivity and
further, it may effect the profitability of the banks.