Reduction in policy rates is not enough

The primary objective of RBI’s monetary policy is to maintain price stability while keeping in mind the objective of economic growth. Having been successful in controlling inflation, the direction of recent monetary policy announcements has been to propel investment/economic growth by reducing the monetary policy rates and reserve requirements for banks.

The Repo Rate is the rate at which RBI provides overnight liquidity to banks against the collateral of government and other approved securities under the Liquidity Adjustment Facility (LAF). Reduction in repo rate normally brings down interest rates in the financial sector. The Statutory Liquidity Ratio (SLR) is the share of Net Demand and Time Liabilities (NDTL) that banks are required to maintain in government securities, cash, gold, etc. Conceptually, when SLR is reduced, the availability of resources in the banking system for lending improves and lending rates come down. The Cash Reserve Ratio (CRR) is the average daily balance banks maintain with the RBI as a percentage of banks’ NDTL.

Banks’ investments in SLR securities is always more than the stipulation. Banks have more than Rs 35 lakh crore in SLR securities as on May 24, as per the RBI bulletin of July, and more than 40% of the central government securities are held by commercial banks. So, reduction in SLR may not have the desired/immediate impact on lending rates.

The CRR was last reduced — to 4% from 4.25% — in February 2013. At that time, the repo rate was 7.75% and SLR was 23%. During the last six and a half years, the repo rate has been gradually reduced by 200 basis points (or 2%) to 5.75%, and SLR by 425 bps to 18.75% today. At the same time, there has been no reduction in CRR since February 2013.

Effective rates charged to the borrowers mainly depends on the MCLR (Marginal Cost of Funds based Lending Rates) of individual banks. Marginal cost of funds, negative carry on CRR, operating cost, tenor premium/discount are the parameters to compute MCLR. Reduction in repo rates reduces the deposit rates/cost of funds to the banks. The balance kept with RBI for CRR purpose carry no interest and so banks have to factor in ‘negative carry on CRR’ while computing/deciding MCLR.

If the average cost of incremental deposits comes to, say, 6.5%, with the negative CRR carry cost, the effective cost to the bank will be 6.77% as the banks are getting only 96% of the funds and 4% of the funds are to be parked with RBI without any return. So, conceptually, only on account of CRR, MCLR is more by 0.27%. Reduction in CRR will marginally, but certainly, reduce MCLR/lending rates.

One noteworthy feature of MCLR-based lending in rupee loans is the difference in weighted average lending rates between fresh disbursements and outstanding loans. In September 2014, the average interest on fresh loans was 11.52% and that on outstanding was 11.90% — fresh loans were priced 0.38% less than the rate on outstanding loans.

However, the difference peaked in January 2017 and as on May 2019, the difference is about 0.55% — fresh rupee loans are charged at 9.86% and outstanding loans were at 10.41%. This may be on account of higher portion of fixed loans (where the interest rates do not change with changes in MCLR), time-lag of one year for resetting interest rates in case of floating rates or higher level of margins over and above the MCLR fixed by the bank in earlier loans. To market loans, fresh loans are now charged lesser than the outstanding rupee loans.

Why no fall in CRR?

The purpose or efficacy of CRR as a monetary control tool and the strengthening of the banking structure cannot be disputed. The RBI is authorised to prescribe CRR without any floor/ceiling rates for securing monetary stability. From 2007 onwards, no interest is paid on CRR balances. To avoid the risk of penalty of non-maintenance of CRR, banks do keep a surplus balance with RBI.

The aggregate deposits of scheduled commercial banks as on July 5 were Rs 127 lakh crore and, along with other liabilities, the total amount kept with the RBI for CRR is more than Rs 5 lakh crore. The RBI earns interest by deploying these funds and, even at 6.75%, the interest income is about Rs 33,750 crore.

As per the RBI Act, after making certain provisions, the net surplus is transferred to the central government. As per the RBI Annual Report released in June 2018, the surplus transferred to the government was Rs 50,000 crore (an increase of 63%) as against Rs 30,659 crore in 2016-17 (the low base level was mainly on account of demonetisation). The surplus transferred was much higher in earlier years: 2015-16: Rs 65,876 crore and in 2014-15: Rs 65,896 crore.

A reduction is CRR or providing compensation to banks on CRR may be positive for a reduction in lending rate, but not so for the revenue generation of RBI/government. When all the major policy rates and SLR are coming down, why leave CRR untouched for the past six and a half years? Is it only to retain the profitability of RBI and revenue of the central government?

(The writer teaches banking at ICICI Manipal Academy)