RBI's new lending rate : A double-edged sword?

The Reserve Bank of India (RBI) on December 17 last year, released the final guidelines on computing interest rates on advances based on the marginal cost of funds, also referred to as Marginal Cost of Funds-based Lending Rate (MCLR). The guidelines will come into effect from April 1, 2016.

Meanwhile, the RBI says that there are many pros arising out of this new methodology. It will help improve the transmission of policy rates into the lending rates of banks. These measures are expected to improve transparency in the methodology followed by banks for determining interest rates on advances, the RBI said.

The Reserve Bank is also expected to ensure availability of bank credit at interest rates that are fair to the borrowers, as well as the banks. Further, it also expects that the marginal cost pricing of loans will help the banks become more competitive and enhance their long-run value and contribution to economic growth.

So, what is this MCLR? The marginal cost of funds will comprise marginal cost of borrowings and return on net worth. The marginal cost of borrowings shall have a weightage of 92% of Marginal Cost of Funds, while return on net worth will have the balance weightage of 8%.

The MCLR is commensurate to interest rates and not the pure cost. The components that will determine MCLR are negative carry of cash reserve ratio (CRR), operating cost and the tenor premium. RBI, in its circular had stated, “In order to improve the efficiency of monetary policy transmission, the Reserve Bank will encourage banks to move in a time-bound manner to marginal-cost-of-funds-based determination of their Base Rate.”

“Although, RBI has cut repo rate by 125 bps since January 2015, under the present system pegged to the Base Rate, banks have cut loan rates by only about 50-60 bps i.e. passed on only about half.  The MCLR system will thus ensure fuller transmission,” says Vivek Moorthy, Professor of Economics at Indian Institute of Management, Bangalore (IIM-B).

This decision comes in the wake of a scenario, where banks (especially PSU banks), have a huge stress on their profits and non-performing assets (NPAs) are surging. There is quite an apprehension in the banking industry that, this policy is not going to help their cause.

Banks’profitability will be reduced

Given the downward interest scenario prevailing right now, the policy is most likely expected to lower the lending rates of the banks. “This might help the industry by making more funds available to them, but this is going to reduce the profitability of the banks,” says Suresh Pai, former banker, who is now Associate Dean of Christ University.

Lower lending rates will reduce the Net Interest Income (NII) — the difference between the interest earned and interest expended. The NII is the single largest source of income for banks, when it comes to Profit and Loss Account. Thus a hit to NII will reflect ultimately by reduced profits.

 Expressing similar apprehensions, Moorthy said, “For simple loans such as consumer durables housing based on EMIs, it is likely that moving to MCLR will lower loan rates and increase amount lent, and thereby, leading to a pick up in activity.”

“However, for corporate and other loans, the credit spread above the cost of fund (whether average or marginal cost) is very crucial and can run into several hundred basis points. The economic environment has worsened in recent years, NPAs are high. At this time, pressurising banks to lower rates since the repo rate has come down may not be a good idea. It may lead to more bad loans,” he adds.

Though bankers, who are mostly concerned with their bottomline, say that they don’t mind lower Net Interest Margin (NIM) till their lending base increases. “This policy is going to be revised on a monthly basis. Though, it is going to have a little impact on our profits, but not much,” says Palaniappan Manickam, Chief Financial Officer, Lakshmi Vilas Bank. “We would have to maintain our CASA (Current Accounts/Saving Accounts), that will compensate for this decrease,” adds Manickam.

Manickam is seconded by Sharad Sharma, Chairman and Managing Director of State Bank of Mysore. “There will be a marginal impact on the NIM,” says Sharma. “But I don’t mind it till my volumes increase, which will compensate for it,” he adds. Pai, who has about 30 years of experience in banking, brings another perspective here. He says that all this does not stop here. With the reduced profits, the internal surplus generation or capital formation of the banks will be lowered. “With the decreased capital formation, that provides support for writing of NPA, the public sector banks will have to depend more on the government grants,” says Pai.

Excess debt not an option

In a scenario, where the government should be trying to control fiscal deficits, this doesn’t look like a good omen. This increased outlay will give a push to inflation in the country. Pai also adds that the lower interest rates give rise to higher propensity of NPAs. “With the lower interest rates, people tend to take loans for riskier ventures, where the chances of defaults are quite high,” says Pai. In fact, the economic recession in 2008 was triggered by reckless lending at lower rates in the United States.

If we have a deeper look at recession in China, we see that a debt binge in China has terribly impacted its fortunes. China saw a 40% increase in debt in the last five years, which is a very dangerous number. Now, given that the bubble did burst in China, its domestic demands fell drastically. The exorbitant indulgence in debt is not a safe option for powering the country’s economy.

Moorthy is of the opinion that this decision will cause a tremendous burden on the banks. “The decision to make banks publish MCLR on a monthly basis from 2017 onwards is, in my opinion, imposing an onerous burden on them.  Until April 2017, they are required to review once a quarter, and I suggest that the frequency for MCLR should be kept to one quarter.  This is the natural frequency for such calculations and decisions since they have to file quarterly reports anyway.  There is ample time before April 2017 for RBI to reconsider before making the banks switch to monthly reporting,” he says.

 Moorthy goes on to call this policy as a double-edged sword. “Regarding consumers they should realise that MCLR is a double-edged sword. It will bring them some rate reduction right now, but when the interest rate cycle turns and the repo rate rises, then they should not complain that loan rates are being raised,” he says.

M Govind Rao, Member of the 14th Finance Commission, has a completely different perspective. He thinks that the policy is better than the previously followed policy. “Right now, we don’t see any transmission of monetary policy. Even if we see it, this transmission takes quite a time. So ensuring this on the monthly basis is a better practice,” says Rao.

“But, I am doubtful that the new system will show this transmission effectively. Transmission is impacted by the adequate supply of savings (household savings) within the country. Also, the commercial banks don’t have much lending space. The RBI also resorts to open market operations to finance the deficit, which is not a good option. So, I am not sure of effective transmission,” adds Rao.

Instead, it would make sense that the RBI should perhaps think about other dimensions of lending, thinks Moorthy.. “Under RBI Governor Raghuram Rajan, the Reserve Bank has given out long overdue bank licences, a welcome policy, and should perhaps wait and see if the new banks add to competition in lending. It should also be noted that bond issuance recently has gone up, since corporate yields have come down a lot.  This can substitute to some extent for bank lending,” says Moorthy.

 This shift to MCLR is focused on ‘Monetary Policy Transmission’. Banks need to be on their feet to ensure that this transmission happens smoothly, and it synchronises with the RBI’s vision. There will be an added onus on them to ensure that their loan portfolio is increased, to ensure profitability.