Rate transmission, the pet peeve of the
Reserve Bank of India has improved substantially following the introduction of external benchmarks with the private banks sniping more than public sector peers.
The overall lending rates have fallen as much as 100 basis points, with the weighted average lending rates for outstanding rupee loans of commercial banks fell 96 basis points between March 2020 and October 21, according to RBI data.
But these rates have fallen more sharply for private sector banks at 109 basis points compared to 85 bps dip for public sector banks and 187 bps for the foreign banks in the country.
The central bank has however cut its benchmark repo rate much higher by 115 bps during the period, and also introduced a number of measures to enhance liquidity of banks to deal with the pandemic induced crisis.
Policy transmission
Policy transmission has been at a much faster pace since the pandemic. In the 19-month period prior to the onset of the pandemic, the benchmark policy 135 bps. But the banks lowered their lending rates only by 15 basis points between March 2019 and March 2020.
A research paper by the Reserve Bank of India economist notes that the transmission of policy repo rate changes to deposit and lending rates of commercial banks (SCBs) has improved since the introduction of external benchmark-based pricing of loans.
The paper said that the transmission showed further improvement since March 2020 on account of sizeable policy rate cuts, and persisting surplus liquidity conditions resulting from various system level as well as targeted measures introduced by the Reserve Bank – cut in the cash reserve ratio (CRR)
requirements, long-term repo operations (LTROs), TLTROs, refinancing window for All India Financial Institutions (AIFIs), sector/segment specific liquidity measures (Mutual Funds, Small Finance Banks, Micro Finance Institutions/Non-Bank Financial Companies), special open market operations and regular OMOs.
External benchmarks
The share of external benchmark-linked loans in total outstanding floating rate loans increased from 2.4 per cent in September 2019 to 32 per cent in June 2021, contributing to a faster and fuller transmission.
There has been a concomitant fall in the share of MCLR-linked loans from 83.6 per cent to 60.2 per cent, over the same period, although these still have the largest share in outstanding floating rate loans.
As lending rates under the external benchmark regime undergo automatic adjustments with the changes in the benchmark rate, banks are incentivised to adjust their term as well as saving deposit rates to cushion their net interest margins and profitability, which then hastens the adjustment in banks’ marginal cost of funds, and MCLRs.
Earlier hurdles
While the Reserve Bank has periodically refined the process of interest rate setting by banks, transmission has hitherto been sluggish as banks relied on their own cost of funds, which is internal benchmarks.
“The systems were also characterised by opacity, especially regarding the interest rate resetting practices for existing borrowers,” the central bank said.
To address these rigidities, the RBI had decided to move to an external benchmark system – an interest rate outside the control of a bank and not necessarily linked to its internal costs – for select categories of loans (viz., all new floating rate personal or retail loans and floating rate loans to micro and small enterprises (MSEs) to the policy repo rate or 3-month or 6-month T-bill rate or other specified benchmarks effective October 1, 2019, and for medium enterprises effective April 1, 2020).