If there’s one riddle that the RBI has been trying to solve for decades, it has been the issue of monetary transmission. Banks have almost always been unable to pass on the RBI’s rate action in its entirety to borrowers — more so in a falling rate cycle. In a bid to crack this puzzle, the RBI has been revamping the interest rate structure — from the pre-PLR (Prime Lending Rate) era, the BPLR (Basic Prime Lending Rate) system in 2003, the base rate regime in 2010, to the much-touted MCLR (marginal cost of funds based lending rate) structure in 2016. The RBI finally looked at external benchmarks in place of bank-specific benchmarks (against which banks peg their lending rates) last year. While the RBI deferred implementing it, the SBI took the lead and linked its savings deposits and short term loans to the RBI’s repo rate in May this year. The largest lender followed this up by introducing a repo-linked home loan product in July. Following the SBI’s footsteps, many banks are now looking to link deposit/lending rates to the RBI’s repo rate.
The question is: Will this aid transmission finally? Under base rate, banks were free to set their base rates using either the average or marginal cost of funds method. With most banks following the former, the bulk of their deposits was unaffected by rate changes, and hence banks were unable to pass on the RBI’s rate action in its entirety. In an attempt to fix this, the RBI introduced the MCLR structure, which mandated banks to calculate their cost of funds based on the latest rates offered on deposits. While purely on math this should have ensured quicker changes in deposit rates and hence lending rates, the MCLR structure failed on several grounds. To start with, it failed to address the key structural reason for weak transmission. Banks source only a minuscule portion of their funds (1 per cent) from the repo window and rely significantly on longer term deposits; hence a cut in repo rate does not immediately reduce their costs. A report by the RBI in 2017 reviewing the working of the MCLR had highlighted some ad hoc and untenable practices followed by banks that impeded transmission. Important among them was the spread game that banks play to arrive at the desired lending rate. Banks assign a mark-up (spread) over the benchmark rate, like the MCLR, based on business strategy or credit risk of the borrower. The RBI had noted that banks charged spreads arbitrarily. The RBI will have to ensure that banks don’t do such tinkering this time around.
Above all, banks have made half-hearted attempts to educate customers on the complex nuances under the MCLR. For instance, loans linked to external benchmark can lead to more frequent changes in the repayment of loans (as against steady EMIs that borrowers are used to), which banks need to educate borrowers about. The RBI will have to ensure that borrowers don’t end up paying a high price for better transmission.