Policy rates: Is it time to adopt an external benchmark?

Nearly 25 years after the Reserve Bank of India (RBI) deregulated banks’ lending rates, India is yet to see an effective monetary policy rate transmission.
Policy rates: Is it time to adopt an external benchmark?

MUMBAI: Nearly 25 years after the Reserve Bank of India (RBI) deregulated banks’ lending rates, India is yet to see an effective monetary policy rate transmission.For instance, when the central bank tweaks repo rate, commercial banks pass on the revised interest rates to fresh loans almost instantly, but existing borrowers continue to be stuck, even if they are under the floating interest rate regime. Moreover, transmission is faster on deposit rates when repo rate is reduced, but slower when it is increased. Likewise, transmission is also faster on deposits (but again based on tenure and amount) in general than on loans.

So last year, RBI governor Urjit Patel constituted an internal study group, which suggested moving to one of the three external benchmarks namely the treasury bill rate, the CD rate or repo rate. Such a move, the central bank feels, will ensure faster transmission and transparency, though banks and financial institutions seem unfavourable.

Reasons for low transmission
Empirical evidence shows that monetary policy actions are felt with a lag of 2-3 quarters on output and 3-4 quarters on inflation and the impact persists for 8-12 quarters.The actual lending rate includes a benchmark rate (based on marginal cost of funds) plus the spread, which varies from bank to bank. More than 21 months after the introduction of MCLR system, a sizeable loan portfolio of banks continues under a combination of base rate and BPLR. As a result, though RBI reduced policy rates by 200 bps since January, 2015, base rate fell by a mere 80 bps. That explains the reason why existing borrowers do not see a significant reduction in interest rates.

Two, the rate rigidity is also because of banks’ liabilities, some 90 per cent of which comprise of deposits with fixed interest rates. Further, over 36 per cent of term deposits have maturity of three years and above, implying their rates get reset infrequently. While the banks’ marginal cost of funds may drop quickly with a cut in fresh deposit rates, the average cost of deposits comes down rather slowly, weakening transmission.
Three, current and savings account funds comprise roughly over 40 per cent of aggregate bank deposits with the share of saving deposits at about 31 per cent. Banks are free to decide saving deposit interest rate, but until recently, most banks left it unchanged at four per cent.

Way forward
Currently, banks have the flexibility to use both internal and external benchmarks, but they seem to have preferred the former as it reflects their cost of funds.Having an external benchmark, RBI believes, is beneficial as it’s transparent, common across banks, and borrowers can compare various loan offers by comparing various spreads. As market rates normally move in line with the central bank’s policy rate, an external benchmark is globally considered and adopted as more appropriate than an internal benchmark for rate transmission, the study group noted.

Moreover, banks and financial institutions suggested following multiple benchmarks, but such a proposal may lead to disorderly pattern, prevent uniformity and confuse borrowers.  Effective transmission is crucial and as RBI has mandated inflation-targeting policy, it is difficult to achieve unless supported by a robust rate transmission mechanism, particularly, on interest rates, so that inflation and growth stay close to the target and potential. Just in case, the economy goes out of whack due to external or internal shocks, policy rate tool could be adjusted to restore stability, but not in the absence of faster transmission.

According to Viral Acharya, deputy governor, RBI, there’s a deeper economic issue in the recommendation to move towards an external benchmark: Who should bear the interest rate risk in the economy? The borrower, depositor or the bank? That’s some food for thought and one can expect meaningful debates and discussion in the months to come.

External Benchmark
RBI believes external benchmark is beneficial as it’s transparent, common across banks, and borrowers can compare various loan offers by comparing various spreads. As market rates normally move in line with the RBI’s policy rate, an external benchmark is adopted as more appropriate than an internal benchmark for rate transmission 

How interest rates evolved

1990: Banks’ lending rates was first deregulated

1994: The first regime of Prime Lending Rate was introduced in 1994. But it was rigid and inflexible in relation to the overall direction of interest rates

2003: To ensure PLR truly reflects the actual borrowing cost, in 2003, banks were asked to introduce the Benchmark Prime Lending Rate (BPLR)

2007: But in practice, about 77 per cent of banks’ loan portfolio as on March of 2007 continued to be at sub-BPLR
In essence, both PLR and BPLR did not produce adequate monetary transmission, defeating the very purpose for which they were introduced for.

2010: In July,  RBI then replaced BPLR with base rate (for which an indicative formula was also prescribed) along with the spread

However, banks still had the flexibility to determine cost of funds — average, marginal or blended cost — to compute base rate, resulting in opacity and as such the average cost of funds did not move much with monetary policy changes due. Moreover, banks often changed the spread, while leaving the base rate unchanged

2016: Given the deficiencies, in April of that year, RBI introduced MCLR. Unlike BPLR and base rate, the formula for computing the MCLR was prescribed.

Yet, it too suffers form the same flaw:  transmission of repo rate to existing borrowers
Channels of transmission 

When RBI tweaks policy rates, they impact the economy through: interest rates, credit channel, exchange rate and asset prices

Impact of interest rates will be via short-term money market rates like call money rate, certificates of deposits, commercial paper, treasury bills and also on medium and long-term instruments like yields on dated government securities and corporate bonds. The impact is typically quick and broadly one-to-one.
Empirical evidence shows that monetary policy actions are felt with a lag of 2-3 quarters on output and 3-4 quarters on inflation and the impact persists for 8-12 quarters.

Shortcomings of MCLR

-Monetary transmission has been low and incomplete 
-Changes in repo rate was significant on fresh loans, but muted for existing loans
-MCLR was uneven across borrowing categories and it was asymmetric over monetary policy cycles: higher during the tightening phase and lower during the easing phase — irrespective of the interest rate system

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