Lending Interest Rate and Challenges – RBI Vs Banks
Transmission of changes in policy interest rate announced by the Reserve Bank of India (RBI) to market and borrowers by reduction in lending interest rate has always been a bone of contention between RBI and Banks since deregulation of lending interest rate in 1994.
Why has RBI been trying various benchmarks for linking lending interest rate?
The effectiveness of a monetary policy depends on achieving maximum growth with reasonable inflation. Repo Rate is one of the major tools used by RBI to achieve the objective of monetary policy. RBI, announces the changes in repo rate based on the assessment of market conditions and global trends. However, the objective of the monetary policy can be achieved only if RBI is able to transmit the magnitude of change in policy rate to market in a speedy manner through banks which are the providers of credit to public. RBI expects banks to pass transmit the change by revising the lending interest rate.
Banking system in India has played crucial roles in the progress of Indian economy, financial inclusion and making banking accessible in every nook and corner of the country. Nationalisation of banks was a major move towards this objective. But over a period, banks too had to shift their focus from service to profitability, to match with the evolving trends in market and demands on banks. As a result, banks have been keen to grab advantage of increases in repo rate by increasing lending interest rate, whereas reluctant in passing the benefit of reduction in policy rate to borrowers. This is evident from the data during the period 2015-2017. During the period, Repo rate was reduced by 2 per cent, but the real transmission to market through reduction in lending interest rate was much lesser and that too varied among banks.
RBI too has been making attempts to ensure proper interest transmission ever since it deregularised lending interest rate. Prime Lending Rate (PLR), Benchmark Prime Lending Rate (BPLR), Base Rate (BR) and Marginal Cost of Lending Rate (MCLR) have been results of earnest efforts of RBI in this regard. But the banks too have been exploiting loopholes in each guideline, mainly for survival. Proposal to link lending interest rate to external benchmark is the latest attempt by RBI to ensure smooth interest transmission. The proposal is the outcome of the Internal Study Group constituted by RBI under the chairmanship of Mr. Janak Raj to study the MCLR based lending rate system.
Why have banks not been able to reduce lending interest rate?
According to Banks, the following factors have been creating impediments in interest transmission.
1. Mismatch between interest rates in fixed deposits and floating rate scheme for lending. Major portion of deposits are contracted at fixed interest rate. Of this 53% of bank’s total deposit is contracted for one year, so cannot reprice interest rate till expiry of another one year from reduction in interest rate.
2. Rigidity of savings bank interest rate. The interest rate in SB remained in the range of 3.5 per cent irrespective of changes in Repo rate. Any reduction in SB interest will only lead to shifting of the fund to higher interest rate bearing fixed deposits.
3. Banks are facing tight competition from other financial instruments and institutions offering better returns. Any reduction in deposit interest rate will lead to shifting of funds from banks to other instruments and institutions creating impediments in fresh resource mobilisation.
4. Banks have been at the receiving end in the recent past for accumulation non performing assets. Any further reduction in lending interest rate alone means decrease in profit and further weakening of balance sheet. Because of contractual obligations with depositors, banks cannot maintain profit by reducing interest rates in existing fixed deposits.
5. The only deposit that does not have a contractual obligation in savings banks accounts and here too banks are facing two challenges:
a. Reduce interest rate of Saving Bank accounts by linking to an external bench mark. Any reduction in interest rate in SB accounts alone will lead to flow of funds to high cost Fixed deposits. If interest rate of fixed deposits also is reduced, funds will flow out of banking system causing strain on resources.
b. Even for leading banks, SB portfolio constitute only 30-35 per cent of deposit portfolio. Hence, even with a 25 basis point reduction in Repo Rate, the maximum benefit a bank can extend to a borrower without affecting profit will be 30-35 per cent of reduction announced in policy rate.
SBI has announced its decision to link interest rate on Savings Bank account with balance above rupees one lakh and also on loans above rupees one lakh to external benchmark of Repo Rate, in tune with the announcement made by RBI during monetary review policy in December 2018. Other banks are waiting for the guidelines to be issued by RBI.
