FROM THE VIEWSROOM. Let banks be

The RBI will soon come out with the final guidelines for calculating base rates under the new marginal cost of funds method. Base rate is the minimum lending rate that banks are free to set after fixing a spread over their total costs, which includes cost of funds. Earlier, banks could use either the average cost of funds or the marginal cost of funds method. Most adopted the former; this, according to RBI, has impeded quicker transmission of policy rate cuts to borrowers. When the RBI lowers its policy rate, banks trim rates only on new deposits. Under average costing, the cost of funds takes time to fall. Under marginal costing, the cost of funds will fall more quickly and may force banks to cut rates more sharply.

Forcing banks to reduce loan rates, however, seems retrograde. Given the weak credit offtake and growing pile of bad loans, banks are already finding it hard to maintain their margins.

The new method is likely to pressure margins further. The issue of transmission has been around for decades now. In an attempt to fix it, the RBI has been working with the rate structure for many years now. But not much has changed. Earlier, banks lent at sub-Basic Prime Lending Rate or their reference lending rates to avoid tweaking their benchmark rates.

Now banks prefer to tinker with the spread rather than the base rate. The RBI has already tweaked some norms for base rate calculations. But these efforts are only half the solution.

Instead of micro-managing banks, the RBI should increase retail participation in the bond market. A deeper bond market (where rates have fallen sharply) is necessary to ensure that rates flow seamlessly between markets.

Deputy Chief of Research Bureau

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