Interest on loans under moratorium case in Supreme Court now: Whose interest is it anyway?

The case relating to interest on loans under moratorium, being heard in the Supreme Court now, has serious implications for the banking sector in particular and the financial stability of the economy in general. Even though the case is still being heard, an academic discussion of this issue, which can have profound consequences, is appropriate. Also, this issue is significant from the investors' perspective.

Borrowers need relief but remedy should not be worse than the disease

It is a fact that a large number of households and businesses, particularly MSMEs, are suffering seriously from the pandemic-triggered crisis. Everything possible should be done to mitigate their suffering. However, remedies should not be worse than the disease. Complete waiver of interest on loans under moratorium will have serious financial consequences, apart from moral hazard issues. If interest and interest on interest were completely waived, as demanded on behalf of the borrowers, there would be loss of income to the tune of Rs 2 lakh crore to the banking system. This would impair the health of the banking system and adversely impact the financial stability of the economy.

PSU banks will be badly hit

Waiver of interest would impact Public Sector Banks (PSBs) more than private sector banks. NPAs of the PSBs are likely to touch 15 percent by the end of this financial year. PSBs incurred a loss of Rs 1,44,000 crore during the 2-year period 2017-19. All PSBs including SBI are quoting below their book values, reflecting investor pessimism. On the other hand, large private sector banks are quoting at 2 to 4 times their book values. This verdict of the market is significant. Around 70 percent of India's banking operations is even now done by the PSU banks. If this significant segment is impacted, it will have very serious and undesirable consequences for the country's already challenged banking system.

Private sector banks are better placed than PSU banks to weather this storm. Particularly the leading names like HDFC Bank, ICICI Bank, Kotak Mahindra Bank and Axis Bank have raised adequate capital from the market. These strong well-capitalized private sector banks will grow increasing their market share, at the expense of the PSBs.

Banking is a commercial activity and banks are financial intermediaries

Banking is a commercial activity under the regulation of the RBI. Once the banking policy is set by the government banks should be left free to decide on what is in the best interest of all stakeholders. Banks are financial intermediaries that raise money from depositors and lend it to borrowers. Interest rate waiver can be done only at the cost of depositors and shareholders.

Depositors and shareholders will suffer

Banks raise money from depositors and shareholders. Interest waiver would be at their expense. This will seriously erode the confidence of depositors and shareholders. Already interest on bank FDs have fallen below the inflation rate. Negative real returns will drive depositors away from bank deposits. Therefore, waiver of interest on loans should not be attempted at all. A possible way out is the waiver of interest on interest with the government footing the bill. But, this will worsen the already stressed fiscal deficit.

The moral hazard issue

Many well-meaning decisions would lead to unintended consequences. Helping stressed borrowers would be a well-intentioned decision. But it is fraught with unintended consequences. Borrowers who didn't opt for the moratorium and paid dues promptly will feel cheated. Worse, borrowers who don't need moratorium might opt for it and deposit/invest the interest that should have been paid and earn a return on the amount. This is a lose-lose situation for the banks, their depositors and shareholders. As the Nobel Laureate economist Milton Friedman famously said, "One of the great mistakes is to judge policies and programs by their intentions rather than by their results."

(V K Vijayakumar is the chief investment strategist at Geojit Financial Services.)