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Last Updated : Oct 09, 2018 09:52 AM IST | Source: Moneycontrol.com

COMMENT: Why EMIs haven't fallen sharply despite RBI's easing cycle

Since January 2015, the Reserve Bank of India (RBI) has cut the repo rate by 175 basis points or 1.75 percentage points from 8 percent to 6.25 percent.

Gaurav Choudhury

Since January 2015, the Reserve Bank of India (RBI) has cut the repo rate by 175 basis points or 1.75 percentage points from 8 percent to 6.25 percent.

The repo rate is the rate at which the RBI lends to banks. A lower repo reduces the banks’ borrowing costs and vice versa. So, ceteris paribus or other conditions remaining same, every repo rate cut should result in a matching drop in banks’ consumer lending rates.

This hasn’t happened.

Bank lending rates have lagged RBI by a significant margin: against a 1.75 percentage point fall in the repo rate in the last 24 months, the average bank lending rate has come down by 0.85-0.95 percentage points.


On Wednesday, RBI Governor Urjit Patel said that the full effect of monetary transmission hasn’t taken place, leaving enough room for banks to cut rates despite an unchanged repo rate.

Banks, however, say that the repo window is not their sole funding source. They also raise funds by collecting customer deposits — current accounts, savings and fixed deposits (FDs) that range from a few months to several years.

Besides, they borrow from banks and institutions, issue bonds and debentures and also use the RBI’s marginal standing facility window, among others.

Therefore, the argument goes, a cut in the repo rate cannot always result in banking lending reduction by an identical margin.

The “base rate,” the floor rate to which all lending rates are linked, is mainly determined by the deposit cost. A high fixed deposit rate would mean banks are incurring a greater cost to court customers to park funds with it.

Unlike many matured economies, Indian banks don’t offer “floating” deposit rates. This has resulted in a situation where lending rates like home loans “float” (meaning, rates can change during the tenure of the loan), while deposit rates are fixed (meaning the returns earned are static during the entire term)

Banks point out that they cannot “borrow” through high return FDs and, at the same time, offer lower loan rates to customers.

To ensure quicker monetary policy transmission, the RBI has mandated banks to follow a “marginal cost of lending rate” (MCLR) approach, which means base rate be computed on the basis of the marginal cost of funds rather than the average cost.

A marginal or incremental cost approach is aimed at faster “transmission” of monetary policy, implying banks will be quick to pass on the benefits to customers every time the RBI cuts the repo rate.

In recent weeks most banks have cut the MCLR, a move often seen as a sign of falling lending rates. Banks are flush with funds given the surge in deposits caused by demonetisation, reducing the need to “borrowing” through high-cost FDs.

In the RBI’s assessment this will lead to a fall in bank interest rates and revive household spending and corporate investment, regardless of the status quo on repo.

“Demonetisation-induced ease in bank funding conditions has led to a sharp improvement in transmission of past policy rate reductions into marginal cost-based lending rates (MCLRs), and in turn, to lending rates for healthy borrowers, which should spur a pick-up in both consumption and investment demand,” the RBI said in its monetary policy statement.

The mount of bad loans have also come in the way for stickier interest rates. Banks are awash with funds but corporates aren’t taking any. Plants have large spare capacity and companies have a stockpile of unsold goods.

The scrutiny over bad loans and tighter norms may have slowed down bank credit growth, with banks willing to hold onto piles of cash, rather than cut rates and lend it risky borrowers.

The central bank, it appears, is acutely aware of this.

“The environment for timely transmission of policy rates to banks lending rates will be considerably improved if the banking sector’s nonperforming assets (NPAs) are resolved more quickly and efficiently and recapitalisation of the banking sector is hastened,” the RBI said.

Lastly, returns earned on a range of popular government-administered small savings schemes such as Public Provident Fund (PPF) and post-office deposits, are also major determinants of which way bank lending rates will swing.

Since last year, India has shifted to a moving interest rate regime for such deposits, implying interest earned on these schemes are linked to market rates that are revised every quarter.

The new system, effective from April 1 last year, has resulted in lower interest rates earned on these schemes given that market rates move in tandem with government bond rates that are currently on a downward trend.

Banks say they are forced to offer high FD rates to maintain its attractiveness as a savings avenue ahead of PPF and post-office deposit plans.

At present, bank FD rates are hovering between 7-8.5 percent for different maturity periods. A PPF deposit, on the other hand, offers an annual return of 8 percent plus tax breaks. It appears, from a purely “returns” point of view, for a customer, it is more attractive to invest in a PPF account than bank FDs.

The RBI said as much on Wednesday, hinting how high small savings rates were blocking bank interest rate cuts.

Monetary transmission — shorthand for lower bank rates in the current context —will quicken if “the formula for adjustments in the interest rates on small savings schemes to changes in yields on government securities of corresponding maturity is fully implemented”, the RBI said in its statement.

Since the introduction of the formula in April 2016, interest rates on small savings are about 65-100 basis points higher, depending on tenor, compared to what they should be if the formula is followed.

“If the spread between small savings rates and bond yields remains wide, the diversion of deposits to small savings would impede a full transmission to bank lending rates,” the central bank said, in a more-than-subtle nudge to the government to cut rates on these deposits that part finances the annual central fiscal deficit.
First Published on Feb 8, 2017 05:55 pm