The RBI left the key repo rate unchanged in its Tuesday’s policy review, after lowering it twice since January. But while the RBI may not have reduced rates this time around, it has laid down the pitch for better policy transmission. A time-bound move towards marginal-cost-of-funds-based computation of base rate and introducing benchmark indices for interest rates will facilitate quicker pass through of policy action on banks’ lending rates over the long term.

Fixing the base rate system

The RBI has reduced the repo rate — the rate at which banks borrow short-term funds from the RBI —by 50 basis points since January. But leading banks have not lowered their lending rates. Why?

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 practice. Banks source only a minuscule portion of their funds from the repo window and rely significantly on longer-term deposits. Hence, changes to policy rates don’t immediately impact their cost of funds-- particularly since banks are free to decide the way they compute their cost of funds.

Banks are currently free to calculate the cost of funds either on the basis of the average cost of funds or on the marginal cost of funds. With many banks using the average cost of funds method, bulk of their deposits are unaffected by rate changes. When the RBI cuts rates, banks trim rates on incremental term deposits; older depositors continue to earn higher rates.

Leading banks have reduced their deposits rates by 25-50 basis points across tenures over the last six months, none of which has resulted in lower lending rates.

The RBI in its policy review has now sought to streamline the computation of banks’ cost of funds by nudging all banks to calculate base rate on the basis of marginal –incremental --cost of funds. This will ensure that deposit rate increases or decreases immediately reflect on the banks’ cost of funds and hence on lending rates.

Move to market rates

Disconnect between rates that banks offer on deposits and market rates has also impeded policy transmission. The RBI in its policy review on Tuesday, seeks to narrow this disparity by establishing an independent benchmark administrator, which will publish various indices of market interest rates. This can be used by banks to price their various products. This proposal is line with the Urjit Patel Committee recommendations that suggested developing a yield curve across various maturities, by providing overnight funds to banks at market-determined rates (term repo).

Currently, short-term market instruments do not tie in with the rates that banks offer on deposits of similar tenure. Many banks still offer about 8-8.25 per cent on deposits with 90- or 120- day tenure. This is almost one percentage point higher than the yield on the 90-day treasury bill (benchmark instrument for short-term borrowings).

External benchmark indices, as suggested by the RBI, will nudge banks to price their deposits more realistically against these market indices. This will ensure quicker transmission of market rates to banks’ deposit rates and hence ensure faster action by banks on lending rates.

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