Obstacles to monetary transmission

Easy money? Just dribbles of it   -  pim pic/shutterstock.com

The cost of funds, basically deposit rates, remains inflexible. Inflation-linked deposit and lending rates could make a difference

The Reserve Bank of India deregulated commercial bank lending rates in 1994 to allow the market forces to play their role in determining such rates. Soon after deregulation, banks were asked to disclose their prime lending rate (PLR) — the rate charged to the prime borrowers. In 2003, the RBI instructed banks to announce formula-based benchmark PLR (BPLR) with the option to lend below BPLR in deserving cases of short-term loans like export credit. However, banks misused this option and the credit market was dominated by the sub-BPLR lending. To plug this loophole, the RBI issued guidelines on base rate system in 2010 prohibiting lending below base rate, barring a few exceptions.

As base rate was not flexible enough to transmit monetary policy signals at the desired speed and magnitude, the RBI introduced marginal cost-based lending rate (MCLR) in April 2016. While existing loans continued at base rate till their maturity, borrowers were given options to switch over to the MCLR system at agreed terms and conditions. The MCLR was also formula-based, but more specific and robust on computation of various components. Moreover, it was tenor-linked except for fixed rate loans above three years, which were outside the MCLR discipline.

After deregulation, the RBI took almost nine years to introduce BPLR, seven years to replace BPLR with base rate and nearly six years to replace base rate with MCLR. Within one-and-a-half years of inception, the MCLR system was found by RBI to be inadequate in transmitting monetary policy signals. Therefore, the RBI has come out with an Internal Working Group Report, which suggests the introduction of a new methodology to link lending rates to the external benchmarks from April 2018.

Upon reflection

There is a need to reflect on what the objective of deregulation is and whether the proposed system is timely or premature. The primary objective of the lending rate deregulation has been price discovery by market forces. If the market forces are not perfect, there may be a case for regulatory intervention to impart market discipline. The RBI has been revising its guidelines on lending rates to improve monetary policy transmission without being reasonably successful in removing credit market imperfections. The focus seems to be moving more towards transmission than price discovery.

The major component of BPLR/ base rate/ MCLR has been cost of borrowed funds. In India, banks’ borrowing from the market through issuance of debentures/commercial papers is negligible. As a part of day-to-day liquidity management, banks’ dependence on call/notice money, CBLO, RBI/market repo together may be around 5 per cent of total deposits. In India, deposit constitutes the bulk of borrowed funds. Cost of fund typically remains inflexible as most of these deposits are contracted at fixed rates. Until and unless this problem is addressed, banks cannot transmit monetary policy signals at the desired speed and magnitude.

Too much lag

There is enough literature to suggest that monetary policy transmission has long and variable lags. While the RBI is fully aware of this ground reality, the obsession with quick transmission gives an impression that the RBI as a regulator would like to nudge commercial banks to fall in line and somehow transmit policy signals even if market forces are imperfect. Under persuasion, banks may oblige the regulator by changing the benchmark lending rate more frequently, but exercise their freedom to decide spread over the benchmark. As a result, the actual lending rate, which is more important for borrowers, may remain less flexible.

It would not be fair to say that banks are not responding to the policy changes. Under MCLR, transmission to lending rate for fresh loans is fairly satisfactory compared to many countries where erosion in the monetary policy transmission is more pronounced. Given the accumulation of large NPAs, the weighted average lending rate ought to be much higher than marginal lending rate. If some banks are committing errors in the computation of base rate/MCLR, the RBI has every right to scrutinise lending rate determination under supervisory review.

The external benchmark is popular in western countries in setting lending rates as banks there depend largely on short-term funds. This makes their cost of funds flexible. In fact, both deposit and lending rates are linked to external benchmark like the London Inter-Bank Offered Rate (LIBOR). This condition is yet to emerge in India.

The RBI’s Internal Working Group analysed 13 possible external benchmarks and narrowed them down to three — CD rate, Treasury Bill rate and policy repo rate —which could be used by banks to set their lending rates. The IWG has also acknowledged that both CD and Treasury Bill markets are too shallow in India to satisfy all preconditions necessary for a suitable external benchmark. Repo rate, being the policy rate, is administered by the Monetary Policy Committee and therefore cannot be treated as a market-determined rate. If banks are asked to link their lending rate to repo rate, without any reference to the cost of funds, banks may oblige by linking it to the benchmark and find ways to manipulate spread over the benchmark to defeat the objective of transmission.

Innovative thinking

Are there any innovative ways to make both sides of the banks’ balance sheet flexible so that transmission could be faster? Accepting bulk deposit at variable rate may not be sufficient to impart cost-flexibility as the size of such deposits is small compared to total deposits. An innovative way to make both asset and liability sides of bank balance sheet flexible is to link both deposit and lending rates to average inflation rate of the previous quarter with appropriate mark-up — 2 per cent for a one-year deposit and 4 per cent for one-year lending, excluding idiosyncratic risk.

In order to incentivise depositors to opt for inflation linked deposit rate, 25 basis points extra may be loaded to the fixed rate deposits, while all fixed rate loans over one quarter may be penalised by 25 bps. This proposal, besides improving monetary policy transmission, will call upon banks to strive for efficiency.

The writer was principal adviser and head of the Monetary Policy Department, RBI

Published on October 29, 2017
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