The Reserve Bank of India’s (RBI) decision on its key policy rates is a keenly-awaited event in the Indian financial calendar, duly hyped by market participants and the media alike. When the announcement actually comes, the focus shifts immediately to the banks, to find out what action they initiate on cue from the regulator.
The popular expectation, following any policy rate cut move, is for an immediate reduction in lending rates by banks.
So, it is natural that when the RBI announced a lowering of its repo rate by 25 basis points last week-end, to which banks did not really respond, we were immediately greeted by headlines such as “RBI cuts rate, but banks won’t budge” or “Rate cut, yes, but cheaper loans not yet”!
What is in sharp focus here is the issue of monetary transmission.
Theoretically, it refers to the process by which changes in monetary policy instruments — such as the rate at which banks borrow overnight money from the RBI or the proportion of deposits required to be compulsorily maintained as cash reserves and not to be lent out (the cash reserve ratio or CRR) — affect the rest of the economy.
It is widely acknowledged that the effect of policy rate changes on output and prices will happen only with a lag and not instantly.
In the context of expectations from banks, the critical issue is the ‘pass-through’ — the degree and speed with which variations in the key policy rates are transmitted through the interest rate spectrum across the financial sector.
Base rate effect
Here, the concept of ‘base rate’, introduced by the RBI from July 2010 assumes importance. Under this regime, each bank is mandated to arrive at its own base rate periodically.
No bank is free to resort to any lending below its declared base rate, even if it may be commercially expedient for it to do so (especially for short-tenors) taking into account its liquidity position and lendable surpluses.
The base rate is, of course, not applicable to certain exempted categories such as loans under the Differential Interest Rate scheme or loans against deposits.
The RBI has historically, even in the past, toyed with the idea of having ‘floors’ and ‘caps’ with regard to lending rates of banks.
It was in 1960 that the RBI first began prescribing a minimum rate of interest on loans extended by banks, which was replaced by a maximum lending rate stipulation in 1968. Two years later, the minimum lending rate or MLR made a comeback, before a ‘ceiling rate’ got reintroduced again in 1976.
It was in the flush of liberalisation that the central bank decided to free lending rates, almost totally, in 1994. The move to deregulate, it was stated then, was meant to do away with the ‘financial repression’ inherent in the previous administered interest rate regime.
The introduction of the concept of a ‘base rate’, almost a decade-and-a-half later, has in some way brought back a certain functional rigidity in the monetary ‘pass-through’ mechanism.
Even though banks have been given freedom to compute their base rates so long as they used a ‘consistent’ methodology, the bed-rock for most banks has practically been the RBI’s own illustrative calculation circulated to them.
Under the RBI’s illustrative approach, the base rate for any bank is arrived at as the sum of its cost of deposits, the negative ‘carry’ on account of CRR, unallocable overheads and the (desired) return on net worth.
The negative carry, resulting from banks not earning any interest on their CRR balances, has been a matter of discussion lately. Some top bankers, especially State Bank of India Chairman Pratip Chaudhuri, have been articulating the need for sharp CRR cuts, on the ground that this will have better ‘pass-through’ effect than any repo rate reductions.
Pass-through factors
The repo rate is effectively an overnight rate, having an immediate impact that is limited only to the money-market and not the overall financial market (it is the rate at which the RBI lends to banks against the collateral of government securities).
It would be quite naive to expect a variation in overnight rates to impact rates on cash credit loans, typically of one year, or home loans extending to 15 or more years.
The above tenor mismatch and the relative inflexibility imposed by the ‘base rate’ concept (howsoever well-intentioned) are seldom appreciated by the media and other market participants.
Lending rates to consumers are also rendered inflexible by the fact that a substantial portion of bank deposits are in the form of long-term deposits at fixed interest rates.
The effect of impounding of deposits by the RBI on an interest-free basis in the form of CRR — not to speak of bad loans, against which there are no returns — further compound the ‘pass-through’ problem.
On top of it, the base rate stipulation effectively takes away the little freedom that banks would have for lending at low rates to creditworthy borrowers opportunistically, at least on a short-term basis.
Globally, most mature markets do not have the stipulation of banks not lending below any particular rate, whether set internally or administered. While the transparency argument in favour of the base rate idea is, no doubt, valid and compelling, its restrictive and inhibitive effect on monetary ‘pass-through’ cannot be ignored.
The repo rate, at the end of the day, is only the tip in the iceberg of the financial market. This is not to deny the potent symbolism and signals on the RBI’s ‘policy stance’ that it can convey.
But to assume that a rate cut on about Rs 1,00,000 crore (the average sums borrowed daily through the RBI’s repo window) to pass through immediately to the banks’ total loans and advances portfolio aggregating to some Rs 53,00,000 crore is a vaulting expectation, which, to quote Shakespeare, “overleaps itself and falls on the other”.
(The author is with the State Bank of Patiala. The views expressed are personal