The trouble with passing on rate cuts

As widely expected, the RBI reduced repo rate to 6 per cent. Much like the previous reviews, Wednesday’s policy statement is not without surprises.

Published: 04th August 2017 04:00 AM  |   Last Updated: 04th August 2017 12:04 AM   |  A+A-

As widely expected, the RBI reduced repo rate to 6 per cent. Much like the previous reviews, Wednesday’s policy statement is not without surprises. When traditional monetary tools fail to do the trick, central banks wield unconventional methods, which the RBI is doing right now. Tucked inside the policy brief was a meaty paragraph on rate transmission and if it can be made “more responsive’’.

The RBI minced no words expressing its unhappiness with banks for not passing on rate cuts to customers. A study group will now recommend a new market-linked benchmark to align rates in real time. If this happens, it’ll be revolutionary in India’s banking system.

Despite years of effort, rate transmission remains a work in progress. Prior to July 2010, all home loans were linked to BPLR, but borrowers complained the rate determination mechanism was opaque and they were paying more than the new borrowers. The BPLR was linked to average cost of funds and retrospective in nature. The RBI then introduced base rates linked to marginal cost of funds, which is incremental and prospective in nature.

But its impact seems limited to new borrowers and select segments like home or auto loans. In other words, large borrowers like corporates and the government aren’t benefitting. The government borrows a staggering `5-6 lakh crore every year and is paying through its nose towards interest payments that eat up roughly 21 per cent of the total revenue.

The RBI believes banks can lower rates further, but lenders are unwilling for a reason. According to SBI Chairman Arundhati Bhattacharya, the bank didn’t raise rates during repo rate hikes as it was linked to the average cost of funds and hence the correction during the lower interest rate regime was minimal.

The RBI is now trying to find ways of reducing rates for past, current and future loans. Only last year did banks switch to MCLR, despite strong opposition, and further changes could cause uncertainty. Moreover, it could affect banks’ interest income—the holy grail of profitability.

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