The implementation by banks of the marginal cost of funds-based lending rate (introduced by the Reserve Bank of India two months back) will be reviewed shortly, according to Governor Raghuram Rajan. The timing couldn’t be better. Not only has the new system failed in achieving what it intended to — reduce costs for borrowers — it has also created a new set of issues for both, borrowers and banks. Familiar with banks’ modus operandi of promptly lowering deposit rates in a falling rate cycle, the RBI designed the MCLR to seize these cuts and instantly make them reflect in the banks’ cost of funds. This forced banks to lower their benchmark lending rates as soon as MCLR was implemented. But the new framework failed to deliver beyond this.

Transitioning to the new regime has handed old borrowers a raw deal. This has always been an inherent challenge when migrating to a new rate structure. But if the RBI wants banks to move their entire loan book to the new system quickly, it will be imperative to put in a sunset clause. Given the paperwork and costs involved in drawing up new contracts, banks are unlikely to rush to move borrowers into the new regime on their own. The larger issue, however, is to tackle some of the flaws coming to light under the MCLR framework. Even as banks set their benchmark rate under MCLR much lower than the base rate, tinkering with the spread has left very little on the table for borrowers. While MCLR is reviewed every month, loan rates are tweaked only annually in most cases.

If the issues are complex, possible solutions appear even more so. Questioning banks on the quantum of spread they add to the MCLR will be retrograde as banks should have the discretion to manage costs and build in the necessary risk premium. Imposing a shorter reset clause to facilitate faster transmission can lead to volatility in EMIs which will be unpleasant for borrowers, particularly in a rising rate scenario. It will also make banks’ task of managing asset-liability gaps more onerous. While it is unclear how the RBI will iron out these issues in the coming months, drawing lessons from the past can help. As a thumb rule, only about half of banks’ funding gets re-priced when the RBI adjusts rates. By designing a framework that forces banks to transmit more benefit than they actually reap, the central bank has got off on the wrong foot. Tempering expectation around transmission can help find a more sustainable solution. Instead of micro-managing pricing decisions, the RBI should foster greater competition. Remember, only a handful of banks is still offering low rates under the new regime. Deepening of the bond market would also help rates to seamlessly flow between markets. Banks can price their deposits more realistically against benchmark instruments, in turn ensuring quicker transmission of market rates to lending rates.

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