NEW DELHI/MUMBAI - India's struggling economy is facing a new challenge: banks are raising interest rates even though the central bank is leaving its rates unchanged, as risks such as surging bond yields and more provisioning requirements erode their profit.
HDFC Bank, India's second-biggest bank by assets, on Wednesday became the latest to raise some rates by 10 basis points. The same day, the Reserve Bank of India (RBI) kept its policy rate unchanged, to "carefully" nurture economic growth.
Other major banks are likely to follow suit, raising concerns of de facto rate increases in an economy that is growing at its slowest pace in three years and needs private investment.
An RBI staff study showed every 100 bps increase in borrowing costs lowers the investment rate by as much as 91 bps.
"Lending rates will move up. We cannot avoid that from happening," the chief of a large state-run bank told Reuters.
Banks are facing a number of threats. Chief among them is that rising inflation has hurt bonds, driving benchmark 10-year yields up more than 100 bps since July, a big concern for banks, which are the biggest buyers of the debt.
Banks are also facing a higher cost of funds, a key expense for the lenders, and more stringent regulatory requirements for their liquidity coverage ratios, according to Ashish Parthasarthy, treasurer at HDFC Bank.
Banks are also being forced to raise deposit rates so they can attract more funds, and they continue to set aside more capital as they clear a near-record $147 billion in soured debt.
Economists see little relief in sight, but are calling on the RBI to step in to support debt markets, including through debt purchases, thus easing at least one of the major challenges banks face.
In a measure of how much margins are being hit, the spread between the 10-year bond yield and a key lending rate, the median one-year marginal cost-based lending rate, has narrowed to only 80 bps from 200 bps in July.
"Lending rates might go up with such a large increase in bond yields," said Soumya Kanti Ghosh, chief economist at State Bank of India.
"Under such circumstances, it is important to help cool off bond yields to protect the overall interest rates from going up and hurting incipient signs of growth."