Linking of retail, MSME loans with external benchmark: Consumer is the loser in tug of war between RBI, banks for fairness in pricing

The infamous tug of war between the Reserve Bank of India (RBI) and margin hungry commercial banks with respect to fair transmission of policy rate cuts to the end-consumer has entered another chapter. Having found no big success even with the marginal cost of funds based lending rate (MCLR) model in prompting, nudging and even forcing banks to cut lending rates meaningfully when the RBI cuts the repo rate, the central bank has now flashed a new weapon to make the banks fall in line—linking all new floating rate loans for housing, auto and MSMEs with external benchmark like repo rate from 1 October. Till now, this was an idea speculated with governor Shaktikanta Das recently speaking about it; now that this is a rule from 1 October. What does this new exercise will do? The idea, as always, is to make banks cut lending rates in a meaningful manner when the RBI signals. In the past, the RBI has tried several methodologies/internal benchmarking systems to bring in transparency and make banks listen to its rate cues. These include the earlier BPLR (benchmark prime lending rate) system to the base rate (minimum lending rate) and later to the MCLR-based calculation was nothing but to bring in more transparency in the interest rate-setting process. [caption id=“attachment_4495283” align=“alignleft” width=“380”] Representational image. Reuters.[/caption] But, no matter what RBI tried, banks still managed to find ways to protect their interest margins. They did so by passing on only a fraction of the RBI rate cuts to the customer when it comes to lending rates, at the same time quickly transmitting the rate hike cues at a much faster pace. In the tug of war between the RBI and banks, the common customer always got a bad deal. Banks have outsmarted the central bank every single time. Time and again the RBI has expressed its displeasure over the lack of proper monetary policy transmission in the banking system. It has been blaming banks for not being transparent enough when setting their lending rates. The regulator has tried to persuade banks to pay attention to the rate cues from the central bank by nudging them constantly. It can’t dictate lending rates to banks because in a deregulated market it’s up to the institutions to decide their rate card. Why is the RBI upset? If one count from the start of this rate cut cycle, the repo rate, at which the RBI lends short-term funds to banks, has come down by not less than 110 bps. How did the banks respond? The benchmark lending rates of major banks have come down by just 15-30 bps. That means, banks still have scope to further reduce their lending rates by at least 80 bps in their lending rates if these entities choose to pass on the full benefit of the RBI rate cuts to the end-borrower. Not only that such a 30 bps cut has not really helped the borrowers, while a quarter basis points decline in deposit rates have hurt bank depositors in a significant manner. Even a 30 bps cut wouldn’t make much difference in the equated monthly installment (EMI) burden of a retail borrower beyond a few hundred rupees. On the other hand, every bps cut in the fixed deposit (FD) rates would hurt the FD holders’ returns badly. It is in this context that the RBI is asking banks to fix their lending/deposit rates to an external benchmark. Linking the lending rate to the repo will certainly bring in more transparency. Presently, it is up to each bank to choose the benchmark rate to prepare their final rate under the MCLR mechanism. By now, it is clear that the MCLR mechanism has failed to ensure that banks pass on the RBI rate cuts to their borrowers.

Once the lending rates are linked to the repo, banks cannot offer any excuses for lack of transparency in the monetary transmission. But the downside for a repo rate-linked interest rate system is that banks may have to introduce more frequent and probably bigger swings in their rate structure depending on the actions of MPC (monetary policy committee) that could impact floating rate borrowers. Such a scenario will arise in the event of a volatile interest rate scenario.

Also, banks still have room to adjust their final lending rates by adding other costs and calculations. So far, banks have always found a way around to protect their interest margins, harming effective monetary policy transmission, no matter what the RBI signals through policies. Changing that approach will be a tough task for the regulator. One needs to wait and watch how the new system will evolve and whether it will have the desired impact on monetary transmission. (This is an updated version of an earlier published piece on Firstpost)