New borrowers are likely to benefit from the Reserve Bank of India’s (RBI’s) policy rate cuts from April when Indian lenders start calculating their minimum loan rate or base rate on the marginal cost of deposits.
The base rate replaced the seven-year-old system of prime lending rate in July 2010 to bring in more transparency. However, the purpose does not seem to have been served. Otherwise, how does one explain the fact that between January and December, local banks have cut their base rate by an average 60 basis points although RBI has cut its policy rate by 125 basis points to 6.75%. Incidentally, the banks have pared their deposit rates by around 100 basis points. One basis point is a hundredth of a percentage point.
According to State Bank of India chairman Arundhati Bhattacharya, banks cannot cut their base rate in tandem with the drop in repo rate simply because the banks are not dependent on market borrowings. For instance, 97% of the State Bank of India’s liabilities are deposits and a cut in repo rate does not automatically lead to a decline in deposit rates. The repo or repurchase rate is the rate at which RBI gives money to commercial banks. When a bank has excess liquidity, it can park money with RBI at the reverse repo rate, which is currently 5.75%. The difference between the repo rate and the reverse repo rate is the interest rate corridor where, in normal circumstances, the inter-bank call money rates move.
Be it repo or reverse repo, such policy or signal rates do not work in isolation. For instance, RBI can cut its repo rate, but if there is scarcity of money in the system, the market rates will not decline. Conversely, if there is ample liquidity in the system, the market rates can go down even though there is no rate cut.
In such a scenario, the reverse repo rate or the rate at which RBI sucks out liquidity from the system becomes the signal rate. RBI uses the lever of cash reserve ratio or CRR to manage liquidity—if it wants to drain liquidity, it raises CRR and it pares CRR when it wants to increase the supply of money in the system. Currently, commercial banks keep 4% of their deposits with RBI in the form of CRR; they do not earn any interest on this. Many bankers feel that a cut in CRR will help faster transmission of the monetary policy.
Let’s go beyond theories and look at the ground reality.
Bankers have many arguments on why they cannot pare their base rate.
One of them is a drastic cut in deposit rates will impact the flow. As a savings instrument, bank deposits compete with small savings schemes of the government that offer high rates and certain mutual fund schemes that are tax efficient. Earnings on bank deposits are taxable.
Even if the banks pare their deposit rates, they get the benefit with a lag effect as the existing deposits will continue to offer the old rate till they mature; the new rate is applicable only to fresh deposits.
Bankers also justify their inability to pass on the full benefit of the policy rate cut to their borrowers saying a decline in rates does not bring down the cost of their entire deposit portfolio. They typically cut the fixed deposits rates but the cost of the so-called CASA or current and savings accounts, which roughly vary between 25% and 50% of commercial banks’ deposit portfolios, remains the same. Banks do not offer any interest rate on money kept in the current account, while most banks are offering 4% on savings account balance.
If we accept these arguments and endorse banks’ unwillingness to transmit the policy rate cut, how do we explain their alacrity in raising loan rates when RBI raises its policy rate? Historically, Indian banks are quicker in monetary transmission when the policy rate rises than when it comes down. The marginal cost-based loan rate for new borrowers will solve the problem, at least partially.
For a permanent solution, the banks would need to focus on garnering floating rate deposits. Currently, such deposits form a minuscule portion of banks’ liabilities. Any change in policy rate will automatically bring down the cost of such deposits and banks will not have to pay the old rate till they mature.
The banks will also have to find an answer to why most of them have kept their savings accounts rate unchanged at 4%. RBI freed the savings bank rate in October 2011. I understand that the Competition Commission of India has been looking into allegations of cartelization among banks in the move to keep the savings rate constant at 4%.
By choosing to overlook the alleged cartelization, RBI has given them a long rope. Now, the new base rate formula seems to be the only way to ensure faster transmission of the monetary policy. The components of base rate include the cost of funds, the so-called negative carry on CRR and the compulsory investment in government bonds, overhead costs and average return on net worth.
However, there has been no uniform rule on the calculation of the cost of funds. Typically, banks look at the blended cost. RBI wants them to look at the marginal cost of funds. Now, there will be no escape for banks from cutting loan rates. A more than 125 basis point drop in commercial paper rates is proof of that.
Also, paring the pile of bad debt will help banks cut loan rates as the cost will come down when they do not need to set aside funds to take care of bad loans.