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Old 28th July 2010, 22:06   #1
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Default A Banker's Perspective on Car Loan Rates

The front page of today’s paper highlighted that interest rates have increased and it is likely to impact people. This forum has many threads with queries on interest rate, pre-closure, (un)hidden charges, etc. Being a Chartered Accountant and a person who has been strongly involved in the car finance industry, I thought I could give a Banker’s perspective on the pricing and the so called (un)hidden charges.

I have tried to simplify this technical subject for the benefit of fellow BHPians

Lending Rates Basics.
Lending Rates are determined by the cost of funds (COF) of the Bank. The gross interest margins i.e. the difference between lending rate and borrowing cost need to be maintained and is dynamic.

The typical equation assuming a COF of 7% is as follow

Lending Rate to Customer (LR)---:10.00%
Borrowing Cost of Bank (COF)----: 7.00%
Gross Interest Margins (GIM)-----: 3.00%
Operating costs (OC)------------: 1.50%
Cost of Defaults (NPA)-----------: 0.50%
Net Interest Margins (NIM)-------: 1.00%

Now if COF increases, the Bank will maintain the GIM by increasing LR. Banks may also take a hit on NIM if there are business pressures but long term sustainability becomes an issue. Hence you will see that LR keeps changing based on the borrowing environment and availability of liquidity.

Cost of Funds Basics

We assume that COF for a bank is the deposit rate, which is not true. There are many associated costs such as

Rate of Interest on Deposits/Loans
Operating cost of raising money by the Banks
Negative carry on CRR requirements
Negative carry on SLR requirements
Negative carry on Priority Sector Lending
Negative carry on Asset-Liability Matching

The above points are discussed in detail below

Rate of Interest on Deposit
This can be seen in the web-site of any bank. Longer the tenure of deposits higher is interest. From a Bankers perspective the COF increases when the tenure of the deposit book is higher.

Operating Costs of raising money by the banks
Deposit is only one method of raising money by the banks. There are many other methods which are largely managed by the Treasury Function. In addition to the cost of loan/deposit there is treasury cost, infrastructure cost, servicing costs, etc which need to be added. We will take this cost at 0.50%

Negative carry on CRR
CRR stands for Cash Reserve Ratio. It is a monetary tool used by RBI to control liquidity in the system. CRR is the amount of cash the banks need to maintain with the RBI. Recently RBI increased CRR by 0.25% to 6% and this sucked out a liquidity of Rs.12500 crs. Since this is in cash form, no interest is earned by the banks. Hence for every Rs. 100 it borrows, the Bank has to maintain Rs. 6 or 6% in CRR. Thus money available with the bank is 94%. Hence if the deposit rate is 7% the actual cost due to CRR requirement is 7.45% (7%/94%)

Negative carry on SLR
Statutory Liquid Ratio is the amount of money which needs to be kept in liquid assets to meet the demand liability of the Bank. This ratio varies from 25-40% depending on RBI. Liquid assets are those assets which are easily saleable and are largely short term government securities, gold, etc. Typically these investments give a return of 4.5%. Hence even though the bank pays 7% on the deposit, 25% of the money will earn 4.5%. Hence 25% of the money will earn 3% less which translates to 0.75% cost.

Negative Carry on Priority Sector Lending.
The government dictates the social obligation of Bank. This is to ensure financial inclusion. Every year the Bank has to lend certain percentage of its total advances to the priority sector like farm loans etc. Though this is important, there are associate costs like higher operating costs due the geographical spread, higher default etc. We will take a notional 0.25% cost

Negative Carry of Asset Liability Matching
This is a very important point from the risk perspective and can make or break a bank. In the late 90’s almost 95% of the NBFC’s collapsed due to Asset – Liability Mis Match and many depositors lost their life time savings and financial services industry went into a tail spin. Asset Liability Mis-Match happens when the bank borrows in the short term and lends long term money. Suppose you borrow for 12 months and lend for 24 months you run the risk that at the end of 12 months you have to payback the deposit but you do not have the money as the person to whom you have lent will pay back only after another 12 months. Hence we need to match our Lending Tenures and our Borrowing Tenures. However the problem is that longer the tenure, higher will be the cost of funds. Hence the bank will have to balance cost by taking a call on the borrowing tenure risk keeping the pattern of lending tenures in mind. This tenure risk is around 0.50%.

Now let us consolidate the above

FD Rate----------------------: 7.00%
Operating Cost of Funds-------: 0.50%
CRR Negative Carry------------: 0.45%
SLR Negative Carry------------: 0.75%
Priority Sector Negative Carry--: 0.25%
Asset – Liability Matching------: 0.50%
ACTUAL COST TO BANK--------: 9.45%

Now if you remember on the lending equation I had mentioned that GIM would be 3%. Hence actual lending rate should be 12.45%!!

Today Private Banks are lending at 10 -11%. Then how are they managing this? They borrow short tenure and lend longer. Loan mix with Used Cars contributing at 14%. Cross sell of Insurance, Manufacturer discounts, Top Up Loans at higher rates etc.

Next question is how do PSU price the loans? Plain and simple- they are just inefficient in pricing. Actually in the long run it is impacting the government. PSU banks are struggling to meet the Basel II Norms and their Capital Adequacy Ratio is way behind in the curve. This is forcing the government to pump in equity which may not be sustainable. We are already seeing inefficient banks getting consolidated with larger and more efficient banks. May be in the long run you will see PSU Banks aligning to the Private Sector Banks in pricing their loan books.

Point on the Foreclosure Charges. This is because the banks need to match their Assets –Liabilities as explained earlier. Normally the Bank will break up its receivables (EMI’s) into buckets of 1, 3, 6, 9,12, 24, 36 months and will do a match borrowing. Hence when you foreclose it impacts the match borrowing. So if you take a 5 year loan and close it in 2 years, the bank would have done a match borrowing of 3-5 years which they will have to live with. Hence the Pre-closure charge has an element of cost recovery and is a deterrent for pre-closing the loan.

I am sure now that you understand the Cost of Funds concept, you will appreciate why all other services are being charged and as the operating margins are very thin, the banks cannot afford under-recovery of operating costs.

I do hope that this has helped you understand the model followed by a private bank with a broader perspective

You always have the choice of different Banks in the Public and Private Sectors and you could go out and still get a better deal every time, why care about these equations anyways!

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Old 28th July 2010, 23:07   #2
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Very Informative Post KPS, thanks for the effort taken in compiling and sharing these facts to us fellow Bhpians !
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Old 29th July 2010, 00:33   #3
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Excellent post KPS.

Could you please elaborate on the drivers behind fixed and floating rate loan schemes?
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Old 29th July 2010, 03:11   #4
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Default Car Loan

KPS, this is really very informative.

It would help if you could analyse the current interest rates and schemes that run with different banks to post it to the benefit of all BHPians.

However, your post is very interesting, especially from the bank's point of view.
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Old 29th July 2010, 08:34   #5
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Default Very informative post

@KPS - I'm no sound with money handling; but your post sounds very informative; the least I can do is *****; hope that makes you

How does bank deal with write-offs? How do they make-up the lost money?
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Old 30th July 2010, 07:34   #6
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Could you please elaborate on the drivers behind fixed and floating rate loan schemes?[/QUOTE]

Thanks shuvc. For floating rate loans, the Bank will borrow money less than 12 months tenure. However keeping the Asset Liability risk they will always cap the amount floating loan they are willing to disburse. Secondly if the bank has a view that interest rates are going to rise they will slow down on floating rate loans. Banks always prefer the have their margins locked in hence there is always a preference for fixed rate loans. It is another story for home loans as in India it is difficult for banks to raise loans for 10-20 years at a competitive rate. Hence in home loans the rates float as the banks are forced the borrow short term and lend long term

Originally Posted by kbalii View Post
It would help if you could analyse the current interest rates and schemes that run with different banks to post it to the benefit of all BHPians.
However, your post is very interesting, especially from the bank's point of view.
Thank kbalii. In todays environment the interest rates are dynamic. It is difficult to say which Bank offers the best deal considering there are so many other factors in pricing like manufacturer discounts, dealer willing to give up his commission etc. You will have to check out the current deals when you plan to buy the car. You will always have some bank pushing aggressively on the rates at some point. A few years back you had ICICI, then HDFC then Axis pushing deals aggressively but they could not sustain it. ON the other hand companies like Kotak who is the oldest player in the car loans industry (since 1991) quietly goes about it business and does not need to play the interest card to go get business. It has such a large customer base, referral business, dealer have high comfort hence they will always park some business have ensured it does big and profitable business. Not every one is well informed on the interest rates and for most the car is more important than the interest rate itself, paying 1% more does not matter

Originally Posted by aargee View Post
How does bank deal with write-offs? How do they make-up the lost money?
Thanks aargee. Normally in the books all loans over 180 days outstanding are written off. However if the quantum on money to be recovered is large the bank will continue its legal recourse to recover the money. When the money is recovered they will write back as income. However when the outstanding becomes very high it will impact the lending rates as it will wipe out the Net Interest Margin (NIM). This was seen in ICICI who from being an aggressive lender increased rates suddenly and eventually out priced it self from the market


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Old 30th July 2010, 10:16   #7
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Another factor which affects the margins of banks is the CASA (Current and Savings Accounts) ratio. This is usually the cheapest source of funds for banks. Many public sector banks typically will have large amounts lying in those accounts from various government departments and other PSUs. This will help them to keep a decent NIM even when the overall fund management may not be as aggressive as that of a private bank. Private banks will have to depend on HNIs and large private enterprises to maintain good balance in the CASA accounts. In any case, HDFC bank is the leader in India with a CASA ratio of about 49% and NIM of 4.3%. SBI also has a healthy CASA of about 47%. The current low deposit interest rate regime will generally result in better CASA figures for banks.
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