Urjit Patel committee’s suggestions may force banks to pass on rate cuts more quickly

There’s usually a lot of fanfare and expectation every time the Reserve Bank of India (RBI) takes the spotlight to review its monetary policy. But the truth is, in recent times, when RBI has raised or lowered its policy rates it hasn’t really mattered to the layman.

This is because banks have been quite tardy in passing on RBI’s rate actions to their depositors and borrowers. When the RBI slashed repo rates by 125 basis points in 2012-14, banks lowered their average lending rates by just 50 basis points.

In the period between March 2010 and October 2011, when RBI raised repo rates by 375 basis points, banks did increase their base lending rates by 275 basis points. But deposit rates crept up by a lower 230 basis points.

So, if you had taken a home loan in 2010 for Rs 50 lakh, your equated monthly instalment (EMI) would have gone up by Rs 8400 from March 2010 to October 2011 as RBI was on a tightening spree. But you would have saved a mere Rs 1600 per month over April 2012 to May 2013, when it eased rates.

So why is it that Indian banks have become more reluctant to pass on the interest rate changes that the RBI is signalling? This is the issue that the Urjit Patel Committee has addressed in its recent report.

Banks decide their lending rates based on their base rates, which they are free to determine. Factors such as the cost of funds, administrative costs and profitability are factored into base rate calculations.

Ideally, when the repo rate is cut, it should result in lower cost of borrowings for banks and hence translate into lower lending rates for borrowers.

But this doesn’t happen in practise. Banks actually source only a minuscule portion of their funds from the repo window, at around 1 per cent of their fund base.

Yes, repo rate changes also affect other short term borrowings of banks. But banks’ dependence on deposits with maturities of less than one year has also been falling; from 50 per cent of total deposits in 2011-12 to a little over a third now. Due to reliance on longer term deposits, changes to interest rates thus don’t immediately reduce their costs. Therefore, when the RBI alters the repo rate, only some segments of the bank’s costs reap the benefits from this.

With the bulk of their deposits untouched by the rate changes, banks are reluctant to re-price their loans. Two, the liquidity situation also determines the pace of transmission. If banks are short of funds to lend, they will need to rely on more expensive market borrowings to fund their business. Thus they may choose not to respond to RBI’s signals.

In a falling rate cycle, pass-through of rate cuts will happen only if there is sufficient liquidity in the system. When RBI embarked on its easy money phase from April 2012 to May 2013, for instance, banks did respond by lowering their deposit rates initially. But they began to drag their feet after significant tightening of liquidity conditions during the second half of 2012-13.

Banks had to raise interest rates to woo depositors, particularly for shorter term maturity. Hence they could not lower their lending rates significantly.

The Urjit Patel Committee tries to solve these problems through a series of measures. To start with, it suggests reducing the dependence of banks on the LAF window at a single rate. Instead, banks will need to source their funds from new ‘term repo’ windows.

In October, the RBI introduced 7-day and 14-day term repos to provide additional liquidity. But instead of providing these funds at a fixed rate, the RBI auctioned off the funds, with banks bidding for the rates at which they would borrow.

Next, the committee suggests moving the policy rate from the fixed repo rate to a target rate for the short-term. This will be benchmarked against the 14-day term repo.

But how will the RBI ensure that the rates set at the 14-day term repo move to its bidding? It will do so by tweaking the amount of funds (liquidity) that it provides to banks at each auction.

By increasing or reducing the money that it offers to banks at various rates, RBI can neatly fine-tune short term interest rates to its requirements.

Liquidity as a tool has worked well in the last couple of months, to alter the cost of borrowings for banks.

In the beginning of October, when the RBI introduced term repos, the cut-off rate for these auctions was 8.8 per cent — closer to the expensive Marginal Standing Facility rate — due to the tight liquidity conditions in the market.

As liquidity improved, aided by the infusion of funds under term repos, the cut-off rate on recent term repo auctions have come down to 8.1 per cent.

Thus. by altering the liquidity, the RBI can impact the cost of funds for banks. The same approach could help set rates for long-term deposits and loans too.

After flagging off 7-day and 14-day term repos, the RBI has recently introduced 28-day repos recently. By 56-day and 84-day term repos, it will become possible to develop a yield curve across various maturities which can act as a benchmark for various money market instruments.

The shift to the term repos may allow more realistic pricing of deposits by banks given that there will now be benchmark instruments for varying terms across the yield curve. It will also allow RBI to maintain a stricter vigil on how banks price their deposits and lending rates across various tenors.

Bank deposits will also track the respective rates on term repos.

By ensuring that the rates on term repos are closely in sync with RBI’s policy rates, any change in policy action will quickly reflect on banks’ lending rates; helping borrowers.

The RBI will now be able to calibrate liquidity to ensure better transmission of its policy action. If it would like higher rates, it can tighten the taps of liquidity. If it would like to reduce rates, it can open them up.

Actually, if the committee’s suggestion were to be fully implemented, the RBI’s monetary policy announcements would cease to be such an eagerly awaited event.

With the central bank working quietly behind the scenes on adjusting the money it lends to banks, where’s the room for big-bang rate cuts or hikes?