Why bank lending rates don’t fall

In essence, the RBI has been unable to exert itself on a crucial parameter, even when that crucial parameter impacts the way the RBI reaches its targets. What then does it tell us the about the efficacy with which the RBI meets its other roles like ensuring that the money of the depositors remains safe? So why are we surprised when NPAs have reached such a high level? It must be kept in mind that banks provide credit with the depositors’ money. All precautions should be taken to protect the depositors’ interest irrespective of the ownership of the banks. A transparent and efficient interest rate structure is an  important part of that.

The transmission mechanism is the critical lever which transmits power from the engine to the wheels. A good engine can do little in the face of a poor transmission system. So it is in the case of the monetary policy.  The key lever here is the policy repo rate, the rate at which the RBI lends overnight to banks. The RBI as the driver moves this lever with the goal of achieving “price stability, keeping in mind growth”. A complete pass through of these interest rate changes would, in theory, impact the aggregate demand of the economy, and thereby should help in the required management of inflation and growth.

But evidence suggests that our transmission is broken. The clutch is clogged, particularly when the policy repo rate is lowered but that leads to no change in the eventual bank lending rate.  Time and again “expert committees” have looked into this, the latest being the “internal study group” to “review the working of the Marginal Cost of Funds Based Lending Rate (MCLR) system”. The group’s report is now open for public discussion and comment.

With the absence of a complete pass through of the transmission process, the RBI has been experimenting with an assortment of benchmark bank lending rates, like the Prime Lending Rate (PLR), the Base Rate and the MCLR. However, all these rates, as the internal study group has opined, could not achieve the desired objectives.

The PLR was meant to declare the best rate for the best borrowers, as decided by the bank. The Benchmark Prime Lending Rate (BPLR), which was introduced in April 2003, was meant to be an improvement on the PLR, and announced a rate below which banks were not supposed to lend.

But the BPLR was self-defeated with the predominance of rates below that. RBI replaced the BPLR with the Base Rate in July 2010.  Under this system, the actual lending rate charged to borrowers was the base rate, plus borrower-specific charges. The banks had the option to calculate these charges as average cost/marginal cost or blended cost. This flexibility encouraged non-transparency and arbitrariness in the system and resulted in weak transmission.  The RBI then introduced the MCLR in April 2016, which essentially provided a formula to calculate the marginal costs.

According the study group report, these three rates are internal benchmarks and are subject to the internal decision of the banks in computing these rates. The transmission from the reduction in the MCLR to lending rates occurred with a lag. In the case of private sector banks, it took almost six months for the transmission from the lower MCLR to actual lending rates. However, in the case of public sector banks, the transmission was not complete even after six months.

In view of this, the study group mentioned that the external bench mark rates would be appropriate for pricing credit. After carefully analysing the pros and cons of 13 possible contenders as a benchmark, the group viewed the T-Bill rate, the Certificate of Deposit (CD) rate and the Reserve Bank’s policy repo rate as being better suited than other interest rates to serve the role of an external benchmark. The group has recommended that all floating rate loans beginning April 1, 2018 be referenced to one of the three external benchmarks.

T-bill rates are market determined but CD rates and policy repo rates are subject to internal decision of the banks and the expert opinion of the MPC respectively, even though these rates indirectly depend on market conditions. As far as the T-bills are concerned, the magnitude depends on cash management of the government and the rate is determined by the liquidity condition.

Evidence suggests that appetite for shorter term T-bills is higher than longer ones. This has impeded the development of an appropriate and relevant term structure of interest rate, implying that market participants are prepared to pay higher interest rates for shorter term bills. Also, the volume of CDs are not large enough to make CD rates an external bench mark.

The Urjit Patel Committee report on the monetary policy framework, which gave us the inflation targeting framework, had recommended that the RBI may eventually switchover to term repo (14 days repo) as the operating target of the monetary policy.

The switch over from the present overnight call rate to term segment will be a welcome move as it will truly reflect the term segment of the money market. The term segment of the repo will be an appropriate external benchmark for linking the same with the floating loan rate.

It is also important to mention that whether the banks adhere to internal or external benchmarks, the onus of transmission of monetary policy is on the RBI.  The RBI has been experimenting with this since 2003 but the transmission of monetary policy has remained a black box.

The RBI has to weigh in on whether this weak transmission is a structural issue with the banks and/or the result of a less developed and less integrated financial market or a failure of the signalling mechanism itself in the sense that it does not achieve what it is supposed to achieve.

In essence, the RBI has been unable to exert itself on a crucial parameter, even when that crucial parameter impacts the way the RBI reaches its targets. What then does it tell us the about the efficacy with which the RBI meets its other roles like ensuring that the money of the depositors remains safe? So why are we surprised when NPAs have reached such a high level? It must be kept in mind that banks provide credit with the depositors’ money. All precautions should be taken to protect the depositors’ interest irrespective of the ownership of the banks. A transparent and efficient interest rate structure is an important part of that.

The author is Editor, SPJIMR.

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