Bank business: funding, the price of credit and credit delivery

Detail

1. How a bank earns: the spread

• A bank is a financial intermediary. It takes money from people who save and lends it to people who need to borrow.
• Spread is the rate a bank charges borrowers minus the rate it pays depositors. This gap is the bank's main source of income (Class 12, Money and Banking).
• Worked example (Class 7, Banks and the Magic of Finance):
• Anand deposits Rs 200 at 2%. The bank lends that Rs 200 to Shreya at 5%.
• Shreya pays interest of 5% × 200 = Rs 10.
• Anand receives 2% × 200 = Rs 4.

• The bank earns Rs 10 − Rs 4 = Rs 6. This is the spread (3 percentage points) in rupees.

• Banks do not lend all their deposits. They keep reserves so they can pay depositors who withdraw cash. Legal reserves such as CRR and SLR are covered in the monetary-policy note.

2. Funding: the types of deposit

Deposit type	Interest	Withdrawals	Typical user
Savings	Yes (low)	Some limits	Households
Current	None	Unlimited transactions	Businesses
Fixed / term	Highest	Money locked for a fixed period	Savers who want a higher return

• CASA ratio = (Current deposits + Savings deposits) ÷ Total deposits × 100.
• CASA is the bank's cheapest money. Current accounts pay nothing, and savings accounts pay little.
• Example: total deposits of Rs 1,000 crore, with current Rs 150 crore and savings Rs 250 crore. CASA = 400 ÷ 1,000 = 40%.
• Higher CASA → lower cost of funds → a wider spread, or cheaper loans.

• Pressure on CASA: savers are moving money into mutual funds and higher-paying term deposits. So banks' funding becomes more costly.

• Green deposits are deposits where the bank promises to use the money only for climate- and environment-friendly projects, such as renewable energy or clean transport. The RBI framework was issued in April 2023. It aims to stop "greenwashing", which means falsely claiming that money is used for green purposes.

3. Measuring bank business: the key ratios

• Credit-deposit (CD) ratio = Total credit (loans) ÷ Total deposits × 100.
• Example: deposits of Rs 1,000 crore and loans of Rs 800 crore give a CD ratio of 80%.
• It was about 80% in 2024-25, because loans grew faster than deposits (verify current).

• A high CD ratio means the bank has little spare money to lend.

  • It competes harder for deposits → deposit rates rise → loan rates rise.
  • An RBI study found that a high CD ratio can push banks to raise lending rates. It also strengthens the pass-through of repo-rate hikes when the RBI is tightening [2].

• Net interest margin (NIM) = (Interest earned − Interest paid) ÷ Average earning assets.

• Example: interest earned Rs 90 crore, interest paid Rs 55 crore, average earning assets Rs 1,000 crore. NIM = 35 ÷ 1,000 = 3.5%.
• NIM measures how profitable the core lending business is. It shrinks when deposit costs rise faster than loan rates.

4. The price of credit: lending-rate regimes

• Why the regime keeps changing: each system was replaced because it passed on the RBI's rate changes to borrowers too slowly or too weakly. (Monetary transmission itself is covered in banking-monetary-policy.)

Regime	Year	How the loan rate is set	Why replaced
Administered rates	pre-1994	RBI fixed the rates	Financial repression (the state keeps interest rates artificially low or controlled)
PLR (Prime Lending Rate)	1994	Each bank's rate for its best borrowers	Rigid
BPLR (Benchmark PLR)	2003	Benchmark PLR	Opaque; most loans were given below the BPLR, so it meant little
Base rate	July 2010	Average cost of funds; a floor below which banks could not lend	Slow to move, because the average includes old deposits taken at old rates
MCLR	April 2016	Marginal cost of funds, meaning the cost of new money; a separate rate for each tenor, with reset periods	Still an internal benchmark that each bank calculates itself, so it moved slowly
EBLR	1 Oct 2019	External benchmark (repo rate, 3- or 6-month T-bill yield, or another FBIL benchmark) plus a spread	Current regime

• Road to EBLR:
• In August 2017 the RBI set up an Internal Study Group to review MCLR, which had been in place since April 2016.

• The group found transmission was weak and recommended moving to an external benchmark-based lending rate (report, October 2017) [3].

• External Benchmark Lending Rate (EBLR) is mandatory for new floating-rate retail and MSME loans.

• The bank cannot change the benchmark. It can only set the spread on top.

• Worked example: repo 5.50% + spread 2.75% = loan rate 8.25%.

  • If the RBI cuts repo by 0.25%, the loan rate falls to 8.00% at the next reset.
  • Under MCLR, the bank would first have to recalculate its own cost of funds.

• Evidence that EBLR works better:

• May 2022 to September 2023: the repo rate rose 250 basis points (1 basis point = 0.01%) [2].
• Weighted average lending rate (WALR) on fresh loans rose 187 bps, about 75% transmission [2].
• WALR on outstanding loans rose only 111 bps, about 44%. This is because many old loans were still on MCLR [2].
• 1-year median MCLR rose 152 bps [2].
• Share of floating-rate loans linked to an external benchmark (June 2023): foreign banks 87.6%, private banks 73.2%, public sector banks 36.1% [2].
• Takeaway: PSB loan books still lean on MCLR, so transmission is slower there.

5. Controlling risk in collateral: loan-to-value (LTV)

• Loan-to-value (LTV) ratio = Loan amount ÷ Value of the pledged asset × 100.
• A lower LTV means the borrower puts in more of their own money. This gives the bank a cushion if the asset's price falls.

• Example: a flat worth Rs 50 lakh with a maximum LTV of 80% allows a loan of at most Rs 40 lakh. The buyer pays Rs 10 lakh as margin.

• Housing loan caps:

Loan size	Max LTV
Up to Rs 30 lakh	90%
Rs 30-75 lakh	80%
Above Rs 75 lakh	75%

• Gold (and now silver) loans: RBI (Lending Against Gold and Silver Collateral) Directions, 2025. Issued 6 June 2025, updated 29 September 2025, effective 1 April 2026 [4]. (NCERT scaffold: flat 75%, "revised slabs for small gold loans in 2025".)

Consumption loan size	Max LTV [4]
≤ Rs 2.5 lakh	85%
Rs 2.5-5 lakh	80%
> Rs 5 lakh	75%

• Silver jewellery, ornaments and coins are now accepted as collateral too [4].
• Bullet-repayment loans (principal and interest paid in one go at the end): LTV is calculated on the total amount repayable at maturity, not just the principal [4].
• Per-borrower limits: gold ornaments 1 kg, gold coins 50 g; silver ornaments 10 kg, silver coins 500 g [4].
• Why smaller loans get a higher LTV: poorer borrowers can raise more cash against a small amount of gold. This supports financial inclusion.

6. Credit delivery: the information problem

• Asymmetric information: the borrower knows more about their own risk than the bank does.
• Adverse selection (Akerlof, "market for lemons", 1970): when lenders cannot tell safe borrowers from risky ones, riskier borrowers are more eager to borrow.
• Stiglitz-Weiss (1981) credit rationing:
• The chain of effects:
  • The bank raises its interest rate.
  • Safe borrowers, whose projects earn modest returns, drop out.
  • Risky borrowers, who may not repay anyway, stay in.
  • Defaults rise, so the bank's actual income can fall.
• Example: at 10% interest, 95% of loans are repaid, so the expected return is about 0.95 × 110 = 104.5 per 100 lent. At 14%, safe borrowers leave and only 88% repay: 0.88 × 114 = 100.3. The higher rate earns less.
• Result: banks ration credit. They refuse some borrowers instead of just raising rates. This hurts small firms and MSMEs most.

• Fixes: collateral (the borrower has something to lose), credit scores (a record of past repayment), and relationship lending (the bank knows the borrower over years).

• Credit information company (CIC): collects borrowers' repayment histories from lenders and produces credit reports and credit scores.

• Regulated by the Credit Information Companies (Regulation) Act, 2005. The RBI licenses them.
• The four CICs: TransUnion CIBIL, Equifax, Experian, CRIF High Mark.
• Lenders must report data more often from 2025 (verify current), so scores reflect recent behaviour faster.

7. Trade and working-capital finance

• Working capital is short-term money a firm needs to buy raw materials and pay wages before its customers pay it.
• Letter of credit (LC): the importer's bank promises to pay the exporter once the exporter presents the agreed documents, such as the bill of lading and invoice.
• The exporter relies on the bank's credit instead of the unknown buyer's.

• Governed by the ICC's UCP 600 rules (Uniform Customs and Practice for Documentary Credits).

• Factoring: a firm sells its receivables (money customers owe it) to a financier, called a factor, at a discount in return for cash now.

• Example: an invoice of Rs 10 lakh is due in 90 days. The factor pays Rs 9.8 lakh today. The 2% discount is the factor's income.

• Law: Factoring Regulation Act, 2011. It was amended in 2021 to let more NBFCs act as factors.

• TReDS (Trade Receivables Discounting System): an electronic platform where MSME invoices on large buyers are auctioned to many financiers. Competitive bids lower the discount rate.

• RBI guidelines 2014; the platforms have operated since 2017 [6].
• Platforms: RXIL, M1xchange, Invoicemart.
• Mandatory buyers: the turnover threshold for compulsory onboarding was cut from Rs 500 crore to Rs 250 crore (Union Budget 2024-25) [5]. It was notified on 7 November 2024 for corporates and CPSEs [7].
• CPSEs must now settle all MSME invoices through TReDS [6].
• Scale: invoices discounted rose from Rs 40,000 crore (2021-22) to Rs 3.47 lakh crore (2025-26) [6].

• Why it matters: it supports the MSMED Act 45-day payment rule, under which buyers must pay MSMEs within 45 days (verify current). MSMEs get cash early, so late payment hurts them less.

• Cross-reference: PSL, PSL certificates and co-lending are covered in financial-inclusion-rural-credit.

Prelims Hooks

• Spread = lending rate − deposit rate. In NCERT's example, the bank earns Rs 6 on Rs 200 (5% vs 2%).
• CASA = (Current + Savings) ÷ Total deposits. Current accounts pay no interest.
• NIM = (Interest earned − Interest paid) ÷ average earning assets. The denominator is not total deposits.
• Order of lending-rate regimes: PLR (1994) → BPLR (2003) → Base rate (July 2010) → MCLR (April 2016) → EBLR (1 Oct 2019).
• Base rate = average cost of funds; MCLR = marginal cost of funds. This is a classic swap trap.
• EBLR benchmarks: repo rate, 3-/6-month T-bill yield, or another FBIL benchmark. It is mandatory for new floating-rate retail and MSME loans.
• Gold/silver loan LTV (effective 1 April 2026): 85% up to Rs 2.5 lakh, 80% for Rs 2.5-5 lakh, 75% above Rs 5 lakh [4].
• CIC (Regulation) Act 2005, with four CICs: CIBIL, Equifax, Experian, CRIF High Mark.
• TReDS: mandatory for buyers with turnover > Rs 250 crore (earlier Rs 500 crore) [5]. Platforms: RXIL, M1xchange, Invoicemart.
• Stiglitz-Weiss (1981): credit rationing comes from adverse selection. Akerlof (1970): market for lemons.

Mains Points

• Transmission and benchmark design: EBLR gives about 75% pass-through on fresh loans but only about 44% on outstanding loans (May 2022-Sept 2023) [2]. PSBs lag in EBLR adoption (36.1% vs 73.2% for private banks) [2]. Moving old MCLR loans to EBLR, and linking deposit rates to benchmarks, would make monetary policy work faster. The trade-off is that bank NIMs become more volatile.
• Funding squeeze: CASA is falling as savings move to mutual funds, and the CD ratio is near 80%. Together they raise banks' cost of funds and push loan rates up [2]. This links bank health to household financialisation of savings and the growth of capital markets.
• Information gaps and MSME credit: Stiglitz-Weiss rationing explains why MSMEs are starved of credit even when rates are low. Collateral-free fixes include CIC data, TReDS (invoices discounted up to Rs 3.47 lakh crore in 2025-26) and factoring. They lend against the buyer's creditworthiness, not the MSME's assets [6].
• Macroprudential LTV caps: graded caps for housing and gold loans limit losses when asset prices fall. The 2025 gold-silver directions give smaller borrowers a higher LTV (85%) but tighten rules on bullet loans. This balances inclusion against consumer protection and financial stability [4].