The Reserve Bank of India has mainly two basic tools under Open Market Operations (OMO) to control price, inflation and money supply.
One is cash reserve ratio or statutory liquidity ratios (CRR/SLR) and the other is Repo rate. When both are triggered, the result is expected to be quicker.
When money supply is tight, with inflation at above normal rate, and the interest rate ruling at a higher level, the market economy experiences lower domestic production and a decrease in consumption due to higher prices.
The OMO tools enable the central bank to reduce CRR/SLR, which eases the tight money market conditions and, combined with reduction in repo rates, is expected to bring down the interest cost, thereby increasing the domestic production and consumption.
This will happen only when banks also pass on the interest reduction benefit to their customers as quickly as possible. Otherwise, the expected results will not be forthcoming. This is what is happening now in the Indian economy.
Base rate calculation
To make the OMO system effective, the RBI directed banks to introduce the system of Base Rate with effect from July 1, 2010, and to enable the banks to stabilise the system of Base Rate Calculation, the time was extended initially up to December 2010, and again up to June 30, 2011.
Prior to this, the Prime Lending Rate (PLR) system was in vogue. Since there was no control on the mechanism of arriving at PLR by each bank, the Base Rate system was introduced.
As per the RBI’s directions, banks may choose any benchmark to arrive at the Base Rate for a specific tenor that may be disclosed transparently. Banks must exhibit the information on their Base Rate at all branches and on their Web sites.
An Illustration of calculation of Base Rate was also given by Reserve Bank as the sum total of a,b,c and d, where (a) is the cost of average deposit; (b) is negative carryon cost of CRR; (c) is unallocable overhead cost and (d) is expected average return on net worth. However, so far no bank has exhibited the method of calculation of base rate. They only give the base rate arrived at by them in their Web site.
No implementation
We have seen in the past that whenever the RBI increased the repo rate, banks immediately rushed to increase the BPLR/Base Rates without giving any justification or information on calculation of BPLR/Base Rate.
During 2012-13, the RBI has reduced the repo rate thrice, each time by 0.25 basis points, aggregating 0.75 basis points, and the immediate response from banks was nil.
Taking their own time, some banks have so far reduced their base rate by 0.25 basis points only, and that too after lapse of considerable time from the period of reduction in repo rate. The State Bank of India so far has reduced the base rate by 0.10 basis points only. Similarly, SBI Group banks have also just followed their leader. For the latest reduction of 0.25 basis points in repo rate on March 18, banks’ response is negative.
Some banks, including SBI, have increased interest rate on short-term deposits, instead of bringing down the deposit rate to effect reduction in average cost of deposits.
Some banks have advocated that the RBI should have reduced CRR and SLR to increase the money supply. But while during the previous occasion CRR was also cut, the response from banks was negative.
Under such circumstances, the open market tool of RBI has failed to bring in the desired result. The culprit is the “base rate” system, which is not effective, and the banks, including SBI and public sector banks, do not want effective implementation of the base rate system.
When an expected sequence of events does not happen, upon reduction of repo rate by the RBI, it will only create an adverse economic effect.
For the tools to be effective, the central bank and the Government must enforce discipline, make banks strictly follow the criteria for arriving at a “base rate”, periodically review the same and make it transparent.
Customers hit
Lakhs and lakhs of customers who have borrowed housing loans and other loans on a Variable Interest Rate system and have already been affected by more than six doses of increase in interest rate over the last 30 months (an increase of about 3 per cent), are the sufferers. They are at the mercy of the banks to expect a small reduction in their interest rate.
On the contrary, banks are adopting unethical practices by offering very low interest rates for new housing loan borrowers, and increasing the interest rate after one or two years, which is blatant discrimination.
The RBI came out with a directive last year that banks should not discriminate between existing and new borrowers. They should be charged the same interest rates according to their risk scoring.
However, this has been kept in abeyance and banks continue to offer very low interest to new borrowers.
This has only resulted in flight of existing accounts from housing finance companies to banks. Why is the regulator silent?
(The author is former MD, PNB Housing Finance Ltd.)