Comments
The London Inter-Bank Offered Rate (LIBOR) is by far the most popular external benchmark in the western world. It is essentially a lending rate and typically above deposit rates of corresponding maturities. Banks in western countries generally rely on short-term funds and offer variable interest rate on deposits, well below LIBOR.
Hence, in western countries, banks conveniently set their lending rates above LIBOR, which cover cost of funds and a spread depending on the risk profile of borrowers. A similar situation is yet to emerge in India.
Indian scenario
In October 2017, the Reserve Bank of India brought out an Internal Working Group Report, suggesting a new methodology for commercial banks to link their lending rates to suitable external benchmarks from April 2018 so that monetary policy transmission will be faster.
In December 2018 policy, the RBI proposed that all retail loans, including floating rate loans to Micro and Small Enterprises, extended from April 2019, shall be benchmarked to either the RBI repo rate, or any other external benchmark produced by the Financial Benchmarks India Ltd (FBIL). As the RBI has not yet issued final guidelines on this, it is not mandatory for banks to switch over to external benchmark in a tearing hurry.
The SBI has adopted the Repo Rate as an external benchmark for pricing savings deposit and all cash credit (CC) and overdraft (OD) above ₹1 lakh, effective from May 1, 2019. While CC/OD lending rates would be at least Repo Rate plus 225 basis points (bps), saving deposits above ₹1 lakh would fetch Repo Rate minus 275 bps. It is not clear whether these spreads are fixed for a considerable period or can be reset every time there is a change in the Repo Rate.
As the current Repo Rate is 6.25 per cent, the minimum CC/OD rate works out to 8.5 per cent, close to the marginal cost-based lending rate (MCLR) and savings deposit rate at 3.5 per cent, the same as now. Bigger segments of both asset and liability sides of commercial banks — term deposit and term lending — still remain in the old pricing system.
The implications
If the Repo Rate is cut in the April 2019 policy, which is most likely, savings deposit rate above ₹1 lakh will be lower than 3.5 per cent. Consequently, savings deposits above ₹1 lakh will be shifted to term deposits. This would increase the cost of funds for SBI and therefore, pass-through of rate cut benefit to borrowers will be difficult without reducing the margin. If the SBI appropriately adjusts spreads to maintain the margin, there would be no transmission.
As of now, the deposit growth is well below the credit growth creating structural deficit of liquidity in the financial system. The RBI has been injecting long-term liquidity through large OMO purchases to even out the liquidity deficit. Unless the liquidity condition is comfortable, deposit rates are unlikely to move southward. Hence, the expectation that banks should cut both deposit and lending rates in response to February Repo Rate cut or even likely Repo Rate cut in April 2019 may not materialise.
Transmission of monetary policy is a natural process with long and variable lags. Any arrangement with automatic transmission will militate against price discovery of both deposit and lending rates. This is as good as shooting the messenger. Moreover, one product with dual pricing is a clear case of distortion, which should be avoided. Most commercial banks are therefore reluctant to follow the SBI model.
Long-term solutions
FBIL has been entrusted with developing financial market benchmarks in India. It is too early to claim that FBIL has been successful in giving LIBOR-like benchmarks to the Indian financial system. Given the RBI’s commitment to maintain price stability under the flexible inflation targeting, the CPI inflation can be used as a suitable external benchmark for the purpose of pricing of both deposit and lending rates.
While one-year deposit rate can be reset on a quarterly basis, at least 2 per cent above the 12-month average CPI inflation rate, all short-term lending rates could be linked to at least 4 per cent above the same. This would ensure monetary policy transmission and make both asset and liability sides of commercial bank balance sheet flexible.
As Repo Rate is essentially an administered interest rate by the Monetary Policy Committee and does not emerge from the market, it is not a suitable external benchmark for the purpose of pricing of both deposit and lending rates. It is better to nurture financial markets to increase their depth and price discovery of financial products, which would eventually improve the process of monetary policy transmission.
The writer is a Visiting Fellow at IGIDR and former Principal Adviser of the Monetary Policy Department, RBI
Comments
COMMENT NOW
Comments
Comments have to be in English, and in full sentences. They cannot be abusive or personal. Please abide by our community guidelines for posting your comments.
We have migrated to a new commenting platform. If you are already a registered user of TheHindu Businessline and logged in, you may continue to engage with our articles. If you do not have an account please register and login to post comments. Users can access their older comments by logging into their accounts on Vuukle.