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The ‘transmission’ worry

Reserve Bank of India (RBI) Governor Shatikanta Das has been off and on expressing his concern over the tepid response from banks in the matter of transmission of changes in policy rates. But the reason for the poor and slow reaction from the banks’ side cannot be wished away. For a better understanding of the crux of the issue, there needs to be a quick look into how the lending rates are computed by banks.

Deregulation and after

In the wake of the financial sector reforms, the RBI deregulated the lending rates of banks in early 1990s and advised them to fix their own floor rate based on the individual bank’s cost of funds and transactions cost. Many methodologies were subsequently tried by the RBI, like the prime lending rate, bench mark prime lending rate, base rate system etc, to help banks determine the bank rate.

Not satisfied with the administration of any of the terms by the banks and feeling sore over the discriminatory treatment meted out to the borrowers, the RBI came out with a more comprehensive formula in April 2016, namely the Marginal Cost based Lending Rate system (MCLR), which is presently in vogue.

Banks have to compute the MCLR based on four components, namely:

a)Marginal cost of deposits and borrowings

b)Negative carry on account of Cash Reserve Ratio

c)Operating cost and

d)Tenor premium

The actual lending rate will be MCLR plus the ‘spread’. The business strategy of the borrower and the credit risk premium will determine the spread. The RBI was of the view that the MCLR system would be more sensitive to changes in the policy rates (ie repo), unlike in the case of the base rate. But unfortunately, it is not so, as per the data collected by the RBI. The Report of the Study Group on MCLR constituted by the RBI (Sep 2017) says the transmission to outstanding rupee loans was significantly lower than the policy rate. As against the cumulative policy rate cut of 2 per cent between December 2014 and August 2017, the weighted average lending rates of banks had come down only by 1.25 per cent. Even this decline was not natural, as demonetisation (November 2016) contributed up to 0.5 per cent to the fall. Post demonetisation, there was a surge in liquidity in the banking system, and many banks announced cut in their MCLR on account of surplus liquidity clubbed with weak off take of credit.

Poor transmission-Why?

Finding the transmission slow and poor across all banks, the RBI felt that lending rates must be linked to an external benchmark at the time of the Policy Review in December 2018, and announced that all the floating rate loans of banks, effective April 2019, shall be benchmarked to an external rate, like the RBI repo rate or the yield on Government of India Treasury bills. However, the final guidelines in this regard are yet to be released by the RBI, and until such time, an effective mechanism for transmission is announced the existing system is allowed to continue.

When the RBI, taking into account the inflationary trends and other economic factors, changes the policy rates, it is expected of all banks to follow suit, as otherwise the measures taken by the RBI towards economic growth and stability will go in vain. But the most important factor that impedes this transmission is the fact that term deposits of banks, which constitute the lion’s share, are under fixed rates while the chunk of credit is under floating rates. If therefore a bank lowers its lending rate, it becomes applicable to all the existing floating rate loans, while on the other hand the parallel reduction in interest rate on deposits will be applicable only for fresh deposits and not the already contracted term deposits. This will hugely impact the bank’s Net Interest Margin (NIM) and thus its bottom line.

At the same time, the RBI hardly needs to remain too concerned over the transmission of changes in key rates for the simple reason that no bank in the context of today’s cutthroat competition can afford to be whimsical in quoting its lending rate. Every bank has to necessarily ensure that its lending rates are almost in alignment with what is prevailing in the industry, as otherwise it is bound to lose good business opportunities.

But if the RBI is quite keen that banks must pass on the changes to its customers without loss of time, it may direct banks to straight away load the differential factor into their lending rates by way of the following mechanism:

(MCLR Borrower specific spread) -(or) (50 per cent of change in policy rate rounded off to two decimals).

For example, if there is cut of 25 basis points ( 0.25 per cent) in repo, banks have to effectively reduce their rate by 50 per cent of 0.25 per cent, ie 0.125 per cent rounded off to 0.13 per cent. This may help to ensure immediate and smooth transmission without any murmurs of dissent from the bankers, as the damage to their NIM on account of the mismatch discussed earlier will only be minimum because of the discounted differential (only 50 per cent reckoned) factored in the said prescription. Still, this is not a foolproof prescription for transmission, as a little tweaking is always possible by banks in the components like ‘operational cost’ or the ‘spread’; but by and large, the mission of the RBI could be achieved.

The writer is Non-Executive Chairman, City Union Bank

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