Context
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In 1994 Reserve Bank of India (RBI), announced a landmark decision to fully deregulate interest rates on advances above Rs 2 lakh.
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Since then, the RBI has introduced four benchmark lending rates for proper pricing of loans and transmission of rates. However, these rate structures have been found to be ineffective for various reasons.
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The RBI has now formed a committee to formulate market-determined benchmarks to ensure a better transmission of interest rates.
What is Monetary transmission?
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Monetary transmission refers to the process by which a central bank’s monetary policy decisions are passed on, through financial markets, to businesses and households.
Base rate system
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It included all those elements of the lending rate that are common across all categories of borrowers.
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Banks are allowed to determine their actual lending rates on loans and advances with reference to the base rate and by including such other customer-specific charges as considered appropriate.
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While all categories of loans are required to be priced only with reference to the base rate, transmission of the RBI rate cuts moved at snail’s pace
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Banks and markets also briefly experimented with the Mumbai inter-bank offer rate (Mibor) on the lines of London’s Libor
Mumbai inter-bank offer rate (Mibor)
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It is a major global interest rate indicator
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In June 1998, the National Stock Exchange had developed and launched the Mumbai inter-bank bid (Mibid) rate and Mibor for the overnight money market.
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However, banks found it difficult to use external benchmarks for pricing their loan products, as the available external market benchmarks (Mibor, G-Sec) are mainly driven by liquidity conditions in the market, and do not reflect the cost of funds of the banks
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MCLR was experiment which was kicked off when Raghuram Rajan was the RBI Governor.
MCLR System
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RBI Governor Urjit Patel said experience with the MCLR system, introduced in April 2016 for improving the monetary policy transmission, has not been entirely satisfactory
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Banks have been selective in their rate cuts in aggressive segments such as home and auto loans, but in many other segments, borrowers are still tied to the base rate, where they can ease more.
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RBI’s rate cuts have not been passed on to borrowers in many segments of the economy.
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The base rate of some banks after the introduction of MCLR has moved significantly less than MCLR.
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The RBI says that the rigidity of the base rate is a matter of concern for an efficient transmission of monetary policy to the real economy
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MCLR failed to bring any cheers to old customers who were stuck with BPLR or base rate-linked rates.
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The RBI is likely to come up with another benchmark lending rate for borrowers, speeding up the transmission of rate cuts to the customers.
What is happening now?
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An internal RBI group suggested switching over to an external benchmark in a time-bound manner so that better rates are available to borrowers.
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The group was constituted by RBI to study various aspects of the MCLR system from the perspective of improving the policy transmission.
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Group found:
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Internal benchmarks such as the base rate/MCLR have not delivered effective transmission of the monetary policy.
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Arbitrariness in calculating the base rate/MCLR and spreads charged over them has undermined the integrity of the interest rate setting process.
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The base rate/MCLR regime is also not in sync with global practices on pricing of bank loans.
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Proposed three possible external benchmarks to which such lending could be tied to going forward.
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Suggestion: the interest rate resets, which are right now at an annual frequency, creating potentially a one-year lag in transmission, can be changed on all floating rate loans to quarterly resets so that transmission would be much faster once the monetary policy changes
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