Monetary Transmission and RBI
As the central banking institution of the country, the Reserve Bank of India (RBI) controls the supply and circulation of currency in the country. Its mandate as originally expounded at the time of its establishment is to ensure the ‘economic well-being of the country’ in the words of its first Governor, Sir Osborne Smith.
Through the recently established Monetary Policy Committee, the RBI’s decision on its key policy rate is a keenly-awaited event in the Indian financial calendar, duly hyped by market participants and the media alike.
When the announcement actually comes, the focus shifts immediately to the banks to find out what action they initiate on the cue from the regulator.
Popular expectation, following a rate cut is for an immediate reduction in lending rates. So, when the RBI cut the repo rate by 25 basis points in the first week of April, we were greeted the next day by headlines like ‘RBI cuts rate, but banks may not budge’! or ‘Rate cut, yes, but cheaper loans not yet’!
What is in sharp focus here is the issue of monetary transmission. Theoretically, monetary transmission refers to the process through which changes in monetary policy instruments such as short-term policy interest rates affect the rest of the economy, particularly, output and inflation.
It is widely acknowledged that the effect of changes in the policy rates on output and prices will happen only with a lag and not instantly.
In the immediate term and in the context of the expectation from banks, the critical issue is the ‘pass-through’ - the degree and the speed with which the variations in the key policy rate is passed through to the interest rate spectrum in the financial sector.
Here the concept of ‘Base Rate’, introduced by the RBI from July 2010 assumes importance.
Each bank is mandated to arrive at its own base rate periodically and since 2010, no bank is free to resort to any lending below its base rate, even when it would be commercially expedient for it to do so (especially for short-tenors) keeping in view its liquidity position and lendable surpluses. This was done by RBI to ensure transparency in the lending rates of banks so that no class of borrowers enjoys the privilege of loans at softer rates than is publicly notified.
The RBI had been historically tight-fisted in its policy regarding interest rate setting by banks. It had initially stipulated ‘caps’ (maximum rates) and ‘floors’ (minimum rates) for loans by banks for various categories of borrowers. This was done in the wake of the licence quota permit approach that guided Indian policy in general before liberalisation in 1991.
It was in the flush of liberalisation in the nineties that the central bank decided to free lending rates almost totally in 1994. It was stated then, that the move to deregulate totally was to ensure that the ‘financial repression’ inherent in administered interest rates is completely removed.
Almost a decade and a half later, the introduction of the concept of the base rate and later, the Marginal Cost of Lending Rate (MCLR) in 2016, have arguably brought in a certain functional rigidity in monetary ‘pass-through’. Even though freedom has been given to banks to compute their rates using any ‘consistent’ methodology, most banks have been following similar formulae.
Under the RBI’s illustrative approach, the rate is arrived at as the sum of a bank’s cost of deposits, the negative carry on account of the reserve balances, unallocated overheads and the (desired) return on net worth.
The repo rate is effectively an overnight rate and has an immediate impact limited only to the money-market and not the overall financial market. (The repo rate is the rate at which RBI lends to banks against the collateral of Government securities). It would be a bit naive to expect a variation in the overnight rate to impact rates for loans which range from one year (the cash credit loan) to 15 or more years. This tenor mismatch and the relative inflexibility imposed by the base rate concept are seldom appreciated by the media and other market participants.
Indian lending rates are also rimmed in by the fact that a substantial portion of deposits is in the form of long-term deposits at fixed interest rates. The effect of impounding of bank deposits by RBI on an interest-free basis in the form of Cash Reserve ratio (CRR) and the impact of bad loans, on which there are no returns, compound the pass-through difficulties. The rate stipulation (whether through base rate or now through MCLR), also effectively takes away whatever freedom banks had to lend at low rates to borrowers opportunistically, on a short-term basis.
Globally, most matured markets do not have the stipulation that banks should not lend below any rate, whether internally set or administered. Though the transparency argument in favour of the base rate idea is valid and compelling, its restrictive and inhibitive effect on monetary ‘pass-through’ has also to be understood.
The repo rate is the tip of the iceberg in the financial market. This is not to deny the potent symbolism and the signal on the “policy stance” that the repo rate conveys. But to assume that a rate cut on about Rs. 1,00,000 crore (the repo outstanding as on a recent date) to pass through immediately to the banks’ total loans and advances portfolio aggregating to about Rs. 88,00,000 crore (the loans outstanding on a comparable date) is a vaulting expectation which would ‘overleap itself and fall on the other’.