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The Banking Ombudsman Conference has recommended waiver of pre-payment penalty on
floating rate loans. However, it is unclear if recommendations are applicable to refinanced
loans too. If made applicable cost of switching loans is likely to fall. Direct impact on earnings
of a penalty waiver is marginal.
Pre-payment penalties increase switching costs for borrowers
Amidst rising competitive pressure pre-payment penalty ('PPP') has helped Indian banks
retain customers, particularly in the home loan market where banks are exposed to ALM
risk. Thus, a PPP waiver (average penalty rate currently stands at 2% of outstanding
principal) would lower switching costs while increasing competitive pressure
However, factors such as service quality, branch network, brand equity and transparency
are likely to continue to favor the incumbents. In addition, our analysis indicates that even
in the current PPP regime interest rate differential needs to be >100bps to incentivise a
customer to switch a loan
Impact of pre-payment charges on bank earnings insignificant
Deliberately simplified assumptions on the floating mortgage book (90% of total), prepayment
(4% for HDFC Ltd and ICICI Bank vs. 2% for SBI) and PPP rates (assumed at a
flat 2% of outstanding loans) indicate income from pre-payments comprised a mere
1.29% (of PBT) for HDFC, 0.58% for ICICI Bank and 0.22% for SBI ('Buy'
recommendations on all three) in FY11
We also assume that the recommendations are applicable to retail home loans. Barring
retail home loans (~10% of non food credit as of May 2011), a majority of retail loans are
priced on fixed interest rate basis
Clarity awaited on refinanced loans; ball in the IBA's court
Currently, a few Indian banks waive PPP if the loan is foreclosed using own funds but
charge PPP if the loan is refinanced. However, we note that as of May 2011 PSU
behemoth SBI had waived PPP charge irrespective of nature and source of pre-payment
It is unclear currently if the waiver will be extended to refinanced loans. However, if made
applicable it would lower loan switching costs and result in more competitive pricing. In
such a case incrementally banks/NBFCs may have to factor in re-financing risk through
higher upfront fees
Overall, we think the NBFC sector's costlier funding structure could imply higher
competitive pressure for them as switching costs for borrowers fall. We note that as of
October 2010, mortgage regulator NHB had waived PPP charges for repayments made
through a borrower’s own funds
At the current juncture, senior bankers tell us that the ball is in the Indian Banker's
Association's court. Overall, the large lenders are divided on applicability to refinanced loans.
Incumbents are likely to recommend that pre-payment charges be retained on foreclosed
loans. However, we note that the Reserve Bank of India in recent months has pushed through
retail customer friendly reforms inspite of opposition from banks
Our earnings and valuation estimates for the stocks under our coverage do not factor in
implications of the committee's recommendations.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
The Banking Ombudsman Conference has recommended waiver of pre-payment penalty on
floating rate loans. However, it is unclear if recommendations are applicable to refinanced
loans too. If made applicable cost of switching loans is likely to fall. Direct impact on earnings
of a penalty waiver is marginal.
Pre-payment penalties increase switching costs for borrowers
Amidst rising competitive pressure pre-payment penalty ('PPP') has helped Indian banks
retain customers, particularly in the home loan market where banks are exposed to ALM
risk. Thus, a PPP waiver (average penalty rate currently stands at 2% of outstanding
principal) would lower switching costs while increasing competitive pressure
However, factors such as service quality, branch network, brand equity and transparency
are likely to continue to favor the incumbents. In addition, our analysis indicates that even
in the current PPP regime interest rate differential needs to be >100bps to incentivise a
customer to switch a loan
Impact of pre-payment charges on bank earnings insignificant
Deliberately simplified assumptions on the floating mortgage book (90% of total), prepayment
(4% for HDFC Ltd and ICICI Bank vs. 2% for SBI) and PPP rates (assumed at a
flat 2% of outstanding loans) indicate income from pre-payments comprised a mere
1.29% (of PBT) for HDFC, 0.58% for ICICI Bank and 0.22% for SBI ('Buy'
recommendations on all three) in FY11
We also assume that the recommendations are applicable to retail home loans. Barring
retail home loans (~10% of non food credit as of May 2011), a majority of retail loans are
priced on fixed interest rate basis
Clarity awaited on refinanced loans; ball in the IBA's court
Currently, a few Indian banks waive PPP if the loan is foreclosed using own funds but
charge PPP if the loan is refinanced. However, we note that as of May 2011 PSU
behemoth SBI had waived PPP charge irrespective of nature and source of pre-payment
It is unclear currently if the waiver will be extended to refinanced loans. However, if made
applicable it would lower loan switching costs and result in more competitive pricing. In
such a case incrementally banks/NBFCs may have to factor in re-financing risk through
higher upfront fees
Overall, we think the NBFC sector's costlier funding structure could imply higher
competitive pressure for them as switching costs for borrowers fall. We note that as of
October 2010, mortgage regulator NHB had waived PPP charges for repayments made
through a borrower’s own funds
At the current juncture, senior bankers tell us that the ball is in the Indian Banker's
Association's court. Overall, the large lenders are divided on applicability to refinanced loans.
Incumbents are likely to recommend that pre-payment charges be retained on foreclosed
loans. However, we note that the Reserve Bank of India in recent months has pushed through
retail customer friendly reforms inspite of opposition from banks
Our earnings and valuation estimates for the stocks under our coverage do not factor in
implications of the committee's recommendations.
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