Has MCLR failed as an internal benchmark in monetary transmission?

The Internal Study Group constituted by the RBI to study and review the various aspects of the marginal cost of funds-based lending rate (MCLR) system submitted its report recently.

The RBI has in recent times expressed its displeasure to banks many times that they have not been passing on the reduction in rates to borrowers and was disappointed that monetary transmission has not been entirely satisfactory. And so from the perspective of improving the monetary transmission and exploring linking of the bank lending rates directly to market-determined benchmarks, the internal study group under the chairmanship of Janak Raj was constituted. The study group was asked to look into the following aspects:

To study whether the MCLR has achieved the objective for which it was introduced

To look into the practices followed by banks for fixing the spread over the
MCLR

To suggest appropriate modification in the MCLR system with a view to strengthening the monetary transmission; and

To make any other recommendation with regard to the setting of interest rates by banks for improving the monetary transmission.

The study group was of the opinion that monetary transmission has been impeded by four main factors:

Maturity mismatch and interest rate risk in the fixed rate deposits, but floating rate loan profile of banks;

Rigidity in saving deposit interest rates;

Competition from other financial saving instruments; and

Deterioration in the health of the banking sector

A major factor that impeded transmission was the maturity profile of bank deposits. Deposits with the maturity of one year and above constituted 53% of banks' total deposits.

The asymmetry in the interest rate setting (fixed for deposits and largely floating for loans) combined with a substantial part of deposits in longer appeared to have constrained banks from quickly transmitting the policy rate cuts to their lending rates, especially on past loans.

The other key finding was that the methodology used for calculating the base rate and the MCLR were different for different banks. The methodologies used were opaque and ad hoc and the spreads charged by banks over the MCLR were arbitrary, too large and excessive to be explained, based on bank-level business strategy and borrower-level credit risk. The group also felt that in the absence of any sunset clause on the base rate, banks have been quite slow in migrating their existing customers to the MCLR regime. Incidentally, most of the base rate customers are retail/SME borrowers.

Based on the findings that MCLR was not helping in monetary transmission, the group has recommended that it is desirable to adopt an external benchmark for setting interest rates by April 2018, after taking into account views of the public and other stakeholders.

It also recommends that banks may be advised to migrate all existing benchmark prime lending rate (BPLR)/base rate/MCLR borrowers to the new benchmark, without any conversion fee or any other charges for the switch over on mutually agreed terms within one year from the introduction of the external benchmark, i.e. by March-end 2019.

Need for an external benchmark?

The study group analysed the pros and cons of 13 possible candidates for the benchmark and narrowed down its choice to three rates, viz. a risk-free curve involving T-Bill rates, the CD rates and the Reserve Bank's policy repo rate.

Within the three, the group felt that RBI's policy repo rate is best suited to serve as an external benchmark since it is robust, reliable, transparent and easy to understand.

Has the RBI succeeded in nudging banks to pass on the benefits of interest rate cuts to borrowers?

It can be seen from the table that while the repo rate has been cut by 75 bps (basis points) since April 2016, banks have cut the MCLR rate with one-year reset by 95 bps - more than the cut in repo rate, contrary to what RBI has been claiming that banks have not been passing on the benefits of repo rate cuts to borrowers. The success of monetary transmission was more pronounced during post demonetisation - 80 bps cut in the MCLR, compared to 25 bps cut in repo rate. While the WALR was higher at 96 bps in respect of fresh rupee loans, it was 50 bps in case of outstanding rupee loans also reflecting the fact that banks were reluctant to pass on the full benefits to outstanding loans vis-a-vis fresh loans.

However, analysis of data published by RBI also reveals that the share of the low-cost CASA deposits in total bank deposits increased from 35.2% in October 2016, to 40.6% in March 2017, due to demonetisation when banks were flush with funds. So did banks pass on the benefits of repo rate cuts to borrowers because of their lower cost of funds? Or was it because RBI was successful in nudging banks?

(The writer is CFA and ex-banker, and is currently with Manipal Academy of Banking, Bangalore)