In this article, we look at the trends in transmission in monetary policy of RBI into bank lending rates. Since the Modi government assumed office the RBI repo rate has declined from 8% to the current rate of 4%, Which is the lowest repo rate till date. It is expected that the repo rate may further be reduced to revive the growth, post the nationwide Lock down imposed on account of COVID-19. This is also in line with the international trend, where central banks across the globe are moving towards easing phase. However, it is to be noted that the lending rates offered by the banks have not seen the commensurate decline pattern during the same period. Repo rate fell from 6.5% in April 2016 to the current level of 4% during the past 4 years and the weighted average lending rate of private banks witnessed a marginal decline from 11.61% to 10.95%, whereas that of public sector banks declined to 9.33% from 11.15% during the same time. This indicates that the monetary policy transmission into the lending rates of banking products has not been efficient and timely.
SOURCE: RBI Data, Company Research
Lending rates are based on marginal cost of funds based lending rate (“MCLR”) which was introduced by RBI in 2016 to transmit the changes in Repo Rates into the lending rates, prior to which base rate, benchmark prime lending rates and prime lending rates were in force. MCLR is calculated by considering the marginal costs of funds, negative carry on account of CRR, operating cost and tenor premium. While calculating the marginal cost of funds, a weightage of 92% is assigned to the marginal costs of borrowings and 8% to return on net worth.
As can be seen in the figure below, the PSU MCLR has come down from 9.50% to 7.83% only from April 2016 to April 2020 and the Private Bank MCLR has reduced from 9.80% to 9.08% during the same period. This is quite perplexing that why the banks are not able to transmit the reduction in policy rates to the end customers.
Higher lending rates directly affect the project feasibility and investment cycle for business organizations. It also leads to lower funds in the hands of businesses and consumers which affects the demand patterns.
SOURCE: RBI Data, Company Research
Part of the reason for the high lending rates is due to the sticky deposit rates of the banks as the term deposits and savings account constitute the major part of banks liabilities. The banks have to reduce the interest rates on them thereby decreasing their marginal cost of funds, in order to pass on the benefit of reduced repo rate. However, the deposits of longer maturities at fixed interest rates makes the marginal cost of funds insensitive to changes in policy rates, especially during the easing cycle, since the bank would have to wait for old deposits with old rates to mature first so as to be able to change the MCLR. Further, since the deregulation of savings deposits interest rates, most banks, especially PSU banks did not alter it (except for the single decrease post-demonetisation, when there was a large influx of surplus liquidity in the banking system). Also, the role of market concentration, competition with other financial products like mutual funds and small saving schemes and top management of banks cannot be denied, who look to maintain their Net Interest Margin.
SOURCE: RBI Data, Company Research
However, MCLR has also not been able to achieve the desired objective of quick and efficient transmission of monetary policy in the banking system. In view of this the RBI constituted an internal study group to study the MCLR regime and finally introduced Repo rate linked lending rates (“RRLR”) with effect from October 1st, 2019 on selected banking products viz. personal loans, home loan and loans to small and micro enterprises, which has now been extended to medium enterprises from April 1st, 2020 as well . Since then, there has been constant decline in the new deposit rates notified by the banks, which is evident from the graph above.
Concluding Thoughts
Interest rate is the key factor of monetary policy to control money supply in the market. In order to achieve the desired macroeconomic goals during easing cycle, a monetary policy transmission should be robust and efficient to attract the business organisations to invest and expand and thereby, stimulate the overall growth. With the introduction of RRLR based lending rates, the banks are now required to reset the interest rate at least once in three months.
Also, it is imperative for the banks to revisit the interest rates structure on deposits so that they are able to align their cost of funds also in accordance with the movement of the repo rates.
These measures could enable quicker transmission of policy rates and the borrowers would be able to receive the benefit of RBI rate cuts in a timely manner.
