Banks say that their funding costs are not related to external benchmarks proposed by the central bank since the primary source of funding is retail deposits
The Supreme Court has asked the Reserve Bank of India to examine within six weeks whether the benefits from cuts in the policy rate were being passed on to consumers. The court passed this order in response to a petition from the MoneyLife Foundation which contended that banks used arbitrary, unfair and discriminatory methods to calculate and charge interest rate – specifically floating rates - on small home, education and consumer loans. The petition said that these methods were violating the fundamental rights of citizens.
The petition’s concerns are borne out by data. RBI officials and reports have often cited that when the policy rate – typically the repurchase (repo) rate – is cut, banks are reluctant to pass on this benefits. However, when RBI increases interest rates, banks are quick enough to pass on this higher burden to consumers.
This piece tries to explain the link between monetary policy actions, their transmission to the broader economy and how it impacts the rates on home, auto loans and so on.
How are floating interest rate loans set?
Fixed rate loans are those whose interest rates are set for the entire tenure of the loan. A large proportion of loans, however, are at floating rates. Here, the interest rate charged to the borrower keeps on changing. The bank resets the interest rate depending on the loan contract: in some cases, these resets happen only over certain periods, say once a quarter, or once a year. In others, the reset happens as the bank deems fit; this is typically linked to changing macroeconomic and financial conditions and events such as monetary policy actions.
How does the reset work? The floating rate is typically linked to a benchmark rate. The final rate one pays for a loan is the benchmark rate plus a spread that the bank charges which includes its costs, fees, factors in the risk etc. In effect
Your loan rate = benchmark rate + spread
The benchmark could be external such as the repo rate, yields on treasury bills and others. These rates are visible to all, outside the control of a bank and common to all banks. Internal benchmarks are based on a bank’s calculations and will include things like its own cost of funds. Indeed, banks in India prefer to use these internal benchmarks for resetting loan rates because they reflect the cost of funds and also because of the perception that current existing benchmarks are not robust enough.
If banks use an internal benchmark for rate resets, how does the repo rate come into play?
To understand this let us go to the concept of the repo rate. The repo or repurchase rate is the rate at which RBI lends to commercial banks. The policy rate is the tool through which the central bank administers monetary policy. Currently, the monetary policy committee is mandated with targeting a 4 percent consumer price inflation within a band of plus/minus 2 percent.
The policy rate changes are a signal for the entire spectrum of interest rates, especially bank rates, to change so that the objective is achieved. Consider a situation where inflation is high. The central bank hikes the policy rate, which in an ideal scenario, is transmitted to all interest rates. This raises the cost of money, people and firms will lower borrowings or consumption and investment. This effectively lowers demand and the inflation rate eases. If the rate hike is not passed on, demand will continue to be high and inflation will not drop. In a country like India, where a huge amount of borrowing comes from banks and non-banking financial companies, it becomes important for the changes in policy rates to reflect in bank rates for monetary policy to be effective.
How are bank rates affected? When the repo rate is changed, it almost immediately impacts short-term money market rates – call money rates, commercial paper rates and so on. It also affects equity prices, exchange rates and rates on government and corporate bonds. These changes in market rates thus impact a bank’s cost of funds and in turn influence the rate they pay depositors and the rate they charge on loans.
So why is it that repo rate changes aren’t reflected in lending rates?
To understand this, a brief diversion into the evolution of the floating rates system is in order. In the early 1990s, RBI deregulated the interest rate system. In effect, banks were free to set their own rates. Since then it has tweaked the ways to calculate the internal benchmarks so that they are more transparent and fully transmit changes in the repo rate.
Over the years, RBI introduced the prime lending rate (PLR) system in 1994, the benchmark prime lending rate (BPLR) in 2003, and the base rate in 2010. These systems were successively introduced because the central bank found that repo rate changes were not being transmitted. RBI tweaked these rate systems to introduce more transparency, it provided indicative formulae so that banks could take into account their cost of funds, operational costs, profit margins, minimum margin to cover regulatory requirements such as provisioning and capital charge etc. But the flexibility that was given to banks in resulted in opaque calculations of the benchmark rates.
In 2016, RBI tweaked the system once more to the Marginal Cost of funds-based Lending Rate (MCLR). This took away some flexibility for banks. The internal benchmark had to be calculated using the marginal cost of funds. (Marginal cost refers to the incremental cost for fresh funding. Average cost is the weighted-average rate of all forms of financing and their respective cost of funds.) Under the base rate, banks could choose between average and marginal cost. Lending rates were expected to change more quickly under the MCLR system precisely because of using the marginal cost.However, this system too didn’t result in effective transmission. Why?
Because banks didn’t follow the system properly or adjusted the spread (the second component of final rates apart from the benchmark) arbitrarily. Simply put, they increased the spread when the MCLR fell, so that the final rate didn’t change much. Indeed, the variations in spread across banks are too large to be explained by bank-level business strategy and credit risk, said the report of a study group constituted by RBI.
The group also said that banks did not calculate the cost of funds properly. Sometimes, they included new components in the base rate formula to adjust the rate to desired levels. At other times, they changed rates only for new borrowers and left out existing borrowers. Mostly, the loan contracts allow for a reset only once a year.
What has RBI done about this?The internal study group mentioned earlier has made several recommendations. It has suggested that
1) all banks move to an external benchmark rate such as the repo rate or yields on treasury bills (which typically reflect the changes in the repo rate quickly)
2) Rates are reset once a quarter instead of once a year
3) Banks fix the spread for the entire duration of the loan (they will be given the flexibility to do so), but cannot change unless there is a credit event (for eg borrower loses his job or moves to a lower-paying job)
4) All loans to be moved to the MCLR system using external benchmark by April 2019
5) Allow banks to pay floating rates on deposits too
Why hasn’t this been implemented so far?
Banks are reluctant to accept these changes. They say that their funding costs are not related to external benchmarks proposed by the central bank since the primary source of funding is retail deposits. They argue that earlier experiments with floating rate deposits didn’t work. They further say that they can’t manage the interest rate risk and will incur losses if RBI's proposals are implemented.RBI’s proposals are just that now, proposals.
1. Monetary Transmission in India: Why is it important and why hasn’t it worked well? Speech by Viral V Acharya, Deputy Governor, Reserve Bank of India; Inaugural Aveek Guha Memorial Lecture, 16 November 2017.2. Report of the Internal Study Group of RBI to Review the Working of the Marginal Cost of Funds Based Lending Rate System, October 2017.