As inflation rises and economic growth slows, concerns about high interest rates charged by banks are growing. The elevated rates are affecting the growth of sectors such as manufacturing and services. While banks are being urged to lower interest rates to make borrowing more accessible, it is crucial to examine whether banks themselves are securing funds at higher costs.
The cost of funds — comprising interest paid on deposits, interbank borrowings, and other financing sources — is a critical factor influencing loan rates. Simply put, there is a direct relationship between the cost of funds and the interest rates banks charge on loans. When the cost of funds rises, banks typically transfer this cost to borrowers through higher interest rates on loans. Conversely, a fall in the cost of funds can lead to more affordable borrowing rates.
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For example, if banks need to offer higher interest rates to attract deposits, they must charge more on loans to maintain profitability. On the other hand, a lower cost of funds allows banks to lower lending rates, encouraging borrowing and spurring economic activity. This dynamic plays a significant role in shaping the broader interest rate environment, impacting both borrowers and lenders.
Cost of funds and the repo rate
The repo rate, set by the Reserve Bank of India (RBI), serves as a benchmark for interest rates across the economy. When the RBI raises the repo rate, it becomes costlier for commercial banks to borrow funds from the central bank. This increases banks’ overall cost of funds, prompting them to charge higher rates on loans to offset the expense.
Despite these challenges, the RBI has maintained a cautious stance on interest rates, prioritising inflation control. The repo rate has been held steady at 6.50% since early 2024, even as high inflation pressures persist. Recent retail inflation data — exceeding the RBI’s comfort level of 6% with October’s reading at 6.2% — has further diminished hopes for a rate cut in the near term.
Rising cost of banks
Indian banks are grappling with increasing costs of funds due to several factors. One major contributor is the repricing of deposits, which has required banks to raise deposit rates to attract savers, especially as customers shift toward higher-yielding fixed deposits. This narrowing of the gap between deposit and lending rates is impacting profitability. Moreover, market borrowing costs are also rising, leading banks to rely more heavily on expensive instruments such as certificates of deposit.
Additionally, a significant shift in customer preferences is contributing to the rise in funding costs. Customers are increasingly favouring bulk deposits and fixed deposits, which offer higher yields but come at a greater expense to banks. The rise in the repo rate earlier in 2024 further accelerated the increase in loan rates, particularly for loans tied to external benchmarks or floating-rate structures. While banks reported improved margins in FY23 due to higher loan rates, the delayed repricing of deposits is now putting additional pressure on their funding costs. Reports indicate that the cost of funds for many banks increased by 90–130 basis points (bps) year-on-year and 20–40 bps sequentially.
As of November 2024, Indian businesses are facing borrowing costs of around 9-10% per annum. This is notably higher than other emerging markets. Brazilian firms are accessing credit at approximately 7-8%, while companies in Indonesia and Malaysia face 6-7% interest rates for loans. These disparities are influenced by various factors such a domestic inflation rates, central bank policies, and the overall economic environment in each country.
Chinese businesses benefit from relatively lower borrowing costs, with interest rates averaging around 3-4%, supported by government policies aimed at fostering industrial growth and maintaining global competitiveness. In developed economies like the US and the Eurozone, businesses typically access credit at rates ranging from 2% to 5%, reflecting stable inflation environments and more accommodative monetary policies.
Impact on lending rates
With rising costs, banks are compelled to adjust lending rates upward. The transmission of higher rates has been faster for loans linked to external benchmarks but slower for those tied to marginal cost of funds-based lending rates (MCLR). Nonetheless, as funding costs continue to climb, lending rates are expected to rise gradually across the board.
Banks anticipate continued pressure on margins over the next two quarters due to rising funding costs. However, if the RBI avoids further rate hikes, these pressures could stabilise toward the end of the fiscal year. For consumers, the persistence of high lending rates will translate into higher costs for loans and credit, further straining household budgets.
The current interest rate environment highlights the delicate balancing act between managing inflation and supporting economic growth. While high interest rates are aimed at curbing inflation, they also risk dampening business investments and consumer spending. A holistic approach is needed to address the twin challenges of inflation control and economic recovery, ensuring that the burden of high costs does not disproportionately affect the common man.