The RBI Governor Raghuram Rajan has handed markets a bonanza by slashing the repo rate — the rate at which banks borrow short-term funds from RBI — by 50 basis points to 6.75 per cent on Tuesday, going beyond the widely expected rate cut of 25 basis points.

By lowering its inflation target for January 2016 to 5.8 per cent from 6 per cent earlier, the RBI has clearly indicated its growing comfort with falling inflation. For borrowers, this move is positive on two counts.

One, given the RBI’s one year expected T-bill real interest rate of about 1.5-2.0 per cent, there is enough scope for further rate cuts, with its 2016-17 inflation target of 5 per cent. Two, by slashing the repo rate by a steep 50 basis points, the RBI has given banks enough headroom to lower lending rates in the next couple of months. Banks have already seen their cost of funds decline substantially over the past year and may now be forced to pass on some of the benefit to borrowers, particularly in view of the RBI’s recent guidelines on base rates.

Yawning gap With the 50 basis points cut in repo rate, the RBI has reduced its key policy rate by a total of 125 basis points since January. While the bold move will set the direction for banks to reduce lending rates, the pace of transmission will be keenly watched.

While banks have been cutting their deposit rates aggressively over the past year, they have not passed on the benefit of the lower cost of funds to borrowers in the form of lower lending rates. One of the main reasons for this has been that banks source only a minuscule portion of their funds from the repo window and rely significantly on longer term deposits. Hence, changes to policy rates don’t immediately impact their cost of funds, particularly since banks are free to decide the way they compute their cost of funds.

Leading banks have reduced their deposits rates by 1-1.25 percentage points across tenures over the last six-nine months, none of which has resulted in lower lending rates.

Setting it right In a bid to force banks to transmit policy rates faster, the RBI recently proposed that banks must calculate their base rate based on their marginal funding cost from April 2016.

Until now, banks could set their base rate (minimum lending rate) after determining a spread over their total costs, factoring in operating costs, cost of funds, and the minimum return on equity they decide. With many banks using the average cost of funds method, the bulk of their deposits are unaffected by rate changes. According to the draft guidelines, banks will have to use the marginal cost of funds. This means that banks’ margins would come under pressure, in a declining rate cycle such as now, as the decrease in lending rates would be higher than the decrease in overall funding cost. This may force banks to cut rates more sharply, which has been the intent of the RBI all along.

The net interest margin of banks with a higher proportion of floating rate loan will be more impacted than banks with higher fixed rate loan portfolios. HDFC Bank and IndusInd Bank are banks with a higher proportion of fixed loans. At a broad industry level, PSBs have a higher share of floating-rate loans, which is likely to put their margins under pressure under the new base rate system. Private banks, on the other hand have a higher share of retail loans (40-50 per cent of their portfolio). Since all non-mortgage retail loans are fixed-rate loans, margin pressure is likely to be minimal. Within the PSU pack, SBI is the only player which has a healthy exposure (21 per cent) to retail.

Also leading private banks, such as ICICI bank, HDFC bank and Axis bank, have a high share of low cost deposits (current and savings account), which enables them to price loans more competitively, as they benefit from lower funding costs. This is the space where PSU banks have been losing market share.

Relief for borrowers While the RBI’s new guidelines for base rate computation will present challenges for some banks, it has paved the way for smoother transmission of rate action for borrowers. To add to this, the RBI’s aggressive rate cut on Tuesday, will force banks to bring down their lending rates. While each bank will decide by how much and when it will lower rates, borrowers can be assured of plenty of action in the coming months.

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