How the RBI is seeking to reduce lending rates without lowering repo

With inflation on the rise, the RBI had little headroom to tinker with its policy repo rate. Hence, the RBI retaining its key rate at 5.15 per cent in the latest policy, was very much on the cards. There was also very limited scope for the RBI to cut rates in the near future. The RBI revising its inflation target upward for the first half of the next fiscalonly highlights the narrow headroom it has to bring down lending rates through conventional policy rate actions.

It is possibly because of this that the RBI has sought to tweak certain liquidity and regulatory norms. Freeing up banks’ funds (selective cash reserve ratio dispensation) and ensuring cheaper long-term money to banks (long term repos) can help lower lending rates in certain category of loans.

Reviewing the liquidity framework

In a bid to simplify the liquidity management framework, the RBI had set up an Internal Working Group in June last year to come up with suggestions. Based on the recommendations of the group, the RBI, on Thursday, streamlined the framework, which can help transmission.

Before looking at the revised framework, let us understand what changed in the past three to five years.

Prior to 2013, banks were allowed to borrow any amount at a fixed rate under LAF (liquidity adjustment facility) at the fixed repo rate. But in October 2013, the RBI decided to move to the term repo and capped the amount banks could borrow under LAF at 1 per cent of NDTL or net demand and time liabilities (essentially deposits). The ‘term repo’ window allows the RBI to supply funds from time to time, with banks bidding for the rates at which they will borrow this money. This had increased the uncertainty for banks.

Additionally, in its April policy in 2016, the RBI made substantial changes in the liquidity management — moving from deficit to neutral liquidity. The RBI also lowered the rate corridor between the repo, reverse repo and marginal standing facility (MSF) rate to 50 basis points from 100 basis points earlier.

Repo rate is the rate at which banks borrow short term funds from the RBI; reverse repo is the rate at which banks lend surplus money to the RBI. If banks exhaust their limits under the repo window, they can borrow under MSF at higher rate. The underlying purpose of narrowing the rate differential between the three, was to ensure quicker transmission.

But post demonetisation, when banks were flush with funds, excess liquidity led to sharp fall in deposit rates. Hence, the RBI reviewed its measures in April 2017 and narrowed the rate corridor between repo, reverse repo and MSF from 50 basis points to 25 basis points.

But the complexities in the existing framework have been impeding transmission.

The RBI has ironed out some of the issues. One, it has retained the weighted average call rate-WACR as the operational rate, to be aligned well with the policy repo rate. It has removed the 1 per cent of NDTL cap on banks raising money at the LAF and withdrawn the daily fixed rate repo and four 14-day term repos conducted every fortnight. But by ensuring that it will provide adequate liquidity (at or around the repo rate) using fixed and variable rate repo/reverse repo auctions, outright open market operations (OMOs), forex swaps and other instruments, the RBI has allowed the system to move between surplus and deficit. This will lead to better transmission.

Long term repos

Over the past year, the RBI has ensured ample liquidity to banks. But one key factor for weak transmission has been the wide spread between 10-year government bonds and shorter tenure bonds. Between September and mid December, the spread between 10-year G Sec and two-year government securities had widened to 90-100 basis points. In a bid to ease the interest rates on long-term government bonds, the RBI has been announcing ‘operation twist’– using proceeds from the sale of short-term securities to buy long-term government debt papers. While this helped in lowering yield on long term G-Secs in the interim, the spread has widened again.

The RBI ensuring long term one-year and three-year repos at current rates (determined by repo auctions) would help banks lower cost of funds and in turn lending rates. Bankers say that currently they are able to access such long term funds at 6.5 per cent plus cost. However, the extent of use of these long term repos will vary across banks.

CRR dispensation

Banks currently need to maintain cash with the RBI on a daily basis. Based on the current CRR requirement, which is 4 per cent of NDTL or deposits, what banks need to set aside is calculated on a fortnightly basis. The RBI has stated that the incremental portion of loans given for auto, housing and MSME segments (post January 31 until July 31) will be deducted from banks’ NDTL to calculate the CRR requirement. For instance, if a bank has ₹10,000 crore of NDTL and lends ₹1000 crore incrementally towards these segment, then CRR requirement will be calculated on ₹9,000 crore (₹360 crore) rather than on ₹10,000 crore (₹400 crore). This would imply that about ₹40 crore of funds gets freed up for the bank to deploy in other interest earnings assets (CRR does not fetch any interest for banks).

This may incentivise few banks to pass on the benefit and lower lending rates in these segments.

COMMENT NOW