Independent Research and Policy Advocacy

Banks must transmit rates for fruitful financial inclusion

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The Supreme Court recently directed the Reserve Bank of India (RBI) to examine if the benefit of lower borrowing costs due to interest rate cuts are being passed on to borrowers, in response to a petition that alleged that banks and NBFCs were setting their interest rates for borrowers in an “arbitrary and discriminatory” manner.

This allegation is neither new nor would it come as a surprise to RBI or the lenders in question. In 2017, taking cognizance of RBI’s interventions over the past two decades, RBI’s Internal Study Group, setup to review the working of Marginal Cost of Funds-Based Lending Rate (MCLR), acknowledged that neither the base rate nor the MCLR-based regimes have been fully effective in ensuring pass-through of interest rate benefits to consumers with existing loans, specifically in a falling interest rate cycle.

Their detailed analysis found a variety of ways in which banks were deviating from the prescribed methodologies, including by increasing credit risk premiums during the tenure of the loan even in the absence of any adverse borrower-level credit event, because of which interest charged for customers with existing loans has remained unchanged or sticky, with changes, if any, happening in a very delayed manner.

We take a step back and take a closer look at why at a systemic level, the failure of this specific channel is particularly concerning. RBI and the government have in their repertoire the interest rate channel, the asset price channel, the exchange rate channel and the credit channel to ensure monetary policy transmits to the real economy. However, in most developing nations, including in India, the exchange rate channel and the asset price channel are underdeveloped and ineffective for the purpose.

When it comes to retail individuals, households and businesses, the credit channel dominates, given that India has a bank-led financial system, as opposed to one that is driven by well-developed financial markets. The RBI can, through banks, enable transmission by influencing the cost of funds available to these segments. However, an equally important sub-channel is the effect on deposit rates, which brings to light another issue that has not received much attention before.

Despite savings deposit rates being deregulated for more than seven years now, there has been almost no change in the rates even as monetary policy cycles have swung in either direction since then. Since deregulation, only a handful of private sector banks raised their deposit rates, the retail depositor base saw absolutely no shifts away from banks who refused to raise their savings deposit rates. Intriguingly, banks were against the deregulation of saving deposit rates arguing that it would lead to a rate war. Such behaviour by banks, both on deposit rates as well as on not passing on benefit of interest rate reduction to existing borrowers, points to a lack of intensity in price competition and calls for increasing the number of banks as a way to bring about competitive differentiation in product and pricing.

Notwithstanding the unfair deal for existing borrowers that the petition raises, the fact that this tool is in fact the best bet for monetary policy transmission in India, and that it has not been effective in achieving its objectives, has serious implications for the benefits of financial inclusion for the low-income consumer and for its policy push by the government. It is well established that economies with lower levels of financial inclusion have weaker monetary policy transmission mechanisms than economies with higher levels of financial inclusion. It is not enough that greater financialization of people’s lives is an objective in itself. Demonetisation for instance was intended as a strong push towards financialization, albeit, a very painful and disruptive one. The use of such a blunt tool signals a failure by the banking system to act as a channel for transmission. Being part of the formal financial system is a prerequisite to the government’s and RBI’s abilities to direct the path towards economic development through the savings and investment decisions of its individual participants.

The RBI can do well to implement recommendations of the Working Group and ensure that its monetary policy is made more credible and effective. These include linking the pricing of assets to one of three external benchmarks, such as the repo, CD rates or T-bill rates, with the spread over it to be set entirely by each bank and to be left unchanged throughout the tenure unless there is a material increase in credit risk. Additionally, banks must be asked to reduce periodicity of interest rate resetting for all floating rate loans from once a year to once a quarter as well as migrate all existing loans to MCLR without any conversion fee for switch over. On the deposit rates, the recommendation is to make banks take bulk deposits at floating rates linked to the external benchmark.

This article first appeared in Moneycontrol.

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