New base rate regime is a firm message from Rajan to banks: No more tricks on common man
The message from the Reserve Bank of India (RBI) with the latest revision in the base rate methodology is very clear.
The central bank, under Raghuram Rajan, doesn’t want banks to play hide and seek any more when it comes to the transmission of policy signals infirm the banking system. In other words, the RBI wants banks to quickly and effectively pass on the reduction in RBI's key rates time to time to the end-consumer, which hasn’t been happening so far.
The central bank has cut its key lending rate by 125 basis points (bps) so far but banks haven’t passed on beyond 60-70 basis points. One bps is one hundredth of a percentage point.
The base rate system was introduced in July 2010 replacing the erstwhile benchmark prime lending rate (BPLR). Before this, banks were lending almost 70 percent of their loans below BPLR that raised questions on the very relevance of this benchmark.
Under the base rate regime, banks were not allowed to lend below the base rate. That brought in more transparency but didn’t solve the problem of lack of monetary transmission in the banking system. Base rates still didn’t reflect the intended signals from the RBI on interest rates, since banks still found a way to manipulate the final lending rate.
The main reason for this was banks were using their average cost of funds. This created distortions since the longer maturity deposits did not easily reflect the changes at the short end and hence banks were unable to pass on RBI rate cuts to the borrower using the average cost system. This is one reason even those banks with lower deposit rates were unable to cut their lending rates to the extent which the RBI has. Also, different banks used different buckets of deposits to calculate base rate.
This is where the RBI has now acted. It has directed banks to switch to marginal cost of funds-based lending rate (MCLR) under which, banks will have to calculate their base rate based on their marginal cost of funds as the name suggests. Marginal cost is calculated based on the latest rate payable on the current and savings deposits. But the final lending rate will include other components of spread to MCLR, which include the tenor premium of the particular loan.
The central bank is hopeful that the new system would make the RBI rate signals a meaningful action for the end-borrower. It should. As per the RBI’s plan, banks will review their base rates according to the new methodology and publicise it frequently. While the new borrowers will certainly benefit from the lower rates, even the existing borrowers too will have the option to move to this new base rate regime at the time of resetting the loan.
Does this mean any significant relief for home and auto loan buyers? Not really. As Firstpost has highlighted before, the overall decline in the home/auto loan EMIs will be a few hundred rupees even if the base rate moves a quarter basis points lower. Also, so far banks have been playing with the spread above the actual base rate to arrive at the final lending rate. But later, the RBI insisted that banks need to have board-approved policy to decide the components of spread.
Nevertheless, the central bank has sent a strong signal to the industry to instil transparency in the system.
In the last one year, the RBI has been trying hard to convince the banks to substantially pass on the benefit of lending rate cuts to the customer by nudging them, even listing the need for effective monetary transmission as a prerequisite for further rate cuts. Banks did pass on part of the lower rates but not significantly.
In fact, in April this year, Rajan came down heavily on banks for not lowering their lending rates despite the RBI cutting its key rate substantially, citing that cost of funds have come down and banks’ argument for not lowering rate is non-sense. “Banks are sitting on money," Rajan said. "Their marginal cost of funds has fallen. The notion that it hasn't fallen is nonsense."
To be sure, banks’ reluctance to cut their lending rates was also due the high share of bad loans in their books, poor demand from corporate borrowers and their inability to lower their deposit rates on account of stiff competition from small savings schemes offered by the government.
While bad loans and poor demand continue, the government has promised to bring down the rate of small savings schemes to enable banks pare their deposit rates. With all banks moving to marginal cost of funds to decide base rate, this shouldn’t be much of a problem now for not lowering lending rate.
Rajan has had a tough time convincing banks to cut their lending rates taking the central bank’s rate signals. While the earlier belief that market competition will eventually force banks to lower lending rates didn’t work well, the RBI has now moved to use its last remaining tools to force banks follow the suit.