By Jatin Bavishi
Three years back, leading industrialists of India criticized ace central banker Raghuram Rajan for his decision to not reduce repo rates (the rates at which the central bank lends money to commercial banks for short term). The repo rates are considered important for boosting investment. Since January 2015, the Reserve Bank of India (RBI) has reduced these rates by 200 basis points (100 basis points is equal to 1 percent), but the industry has now found new villain— the commercial banks. These sprawling institutions are accused by RBI and others for not passing down the benefits of lower repo rates to their clients. Just to illustrate, State Bank of India’s (SBI) base rate has dropped by just 65 points whereas, during the same period, policy rates fell by 200 points.
RBI forms a study group
In response to the apparent inflexibility of banks, the RBI formed a study group during its bimonthly meeting on 2nd August 2017. The role of this group will be to explore reasons for the slow transmission of policy rates into lending rates. It will also propose ways to link the lending rates directly to market determined benchmarks.
It has been expected that if loan rates are linked to the market, banks will be more proactive in responding to RBI policies. This will be the third review of the benchmark bank lending rate in last the seven years. The report will be submitted on 24th September, as declared by the RBI.
Why the poor transmission?
Despite fulfilling an important social objective of providing finance, commercial banks seek to get highest profits in their books. Certain institutional factors like Prime Sector Lending (PSL) norms and limitations on putting the funds to high risk-high return options (like equities) limit the choices available to these banks with regard to maximizing their returns. For example, under the PSL norms, all bank branches have to compulsorily disburse 40% of their loans towards agriculture, micro and small enterprises, poor people for housing, students for education and other low-income groups.
The chief source of profit for banks, given this limitation, is the differential between what they pay as interest to lenders and what they get from borrowers. The situation is quite contrary to countries like USA where banks park an important portion of their money with the Fed (central bank of USA). Since central banks form an important part of the clientele in the West, their policies have a direct bearing on the actions of the commercial banks. Moreover, a huge proportion of money in India lies outside the clutches of formal institutional channels, crippling the efficiency of seamless pass through.
Bank Rates versus MCLR
Apart from the operational mechanism, internal policies also enable banks to keep rates high. From April 2016, banks have been asked to change lending mechanism from a ‘base rate’ approach to ‘Marginal Cost of Funds based Lending Rates’ (MCLR) approach. In the ‘base rate’ approach, change in repo rates did not feature in the calculation used by banks to arrive at the final number. Under MCLR approach, however, this change has to be compulsorily incorporated in the calculation.
In the past, the ‘base rate’ approach had led to banks paying no attention to policy rates, but it is difficult to avoid it under the new regime. Ideally, this shift should foster transmission of policy rates into lending rates. The RBI feels that the transmission has not been entirely satisfactory, although they agree that it has been better than before. The study group will explore this aspect and will try to resolve the problem.
The way ahead
We may not see a full conversion of policy rates along market-oriented lines, but we can reasonably expect a change in the current arrangement. The whole purpose of interest rates is to serve as a launchpad for investments. The RBI was hesitant to reduce rates in the last three quarters owing to fears of inflationary tendencies. Recent data has shown that inflation has been comfortably sitting at a lower range (1.54% in June 2017). At the same time, investments have been languishing at 27.9% of GDP. This is because the private sector is not motivated enough to invest.
In a low-inflation low-investment situation, interest rates should be falling, but their slow relay is creating a hindrance. However, the main problem is the Non-Performing Assets (NPA’s) of banks on the one hand and the unserviceable loans of large companies on other. This means that even if banks lower lending rates, there would not be many willing to take loans for investment purposes because they are already riddled with high debts. The RBI and the government must explore ways to break from this paralysis if they want any serious action to spur investment and growth.
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