Why RBI wants to move away from base rate, MCLR

Each bank deciding its own benchmark lending rate has impeded transmission

Banks have almost always been unable to pass on the RBI’s rate action in its entirety. Lending rates have always moved with a lag and by smaller proportions in relation to policy rates.

In an attempt to fix these issues, the regulator has been revamping the interest rate structure time and again. In its latest attempt, the RBI had shifted from the base rate to the MCLR regime.

But MCLR yet again failed to deliver to expectations. What gives?

The core issue

The crux of the problem, under both base rate and MCLR, lies in the fact that each bank decides its benchmark rates — against which lending rates are benchmarked — based on its costs and profitability. Hence, banks’ rate actions cannot follow a harmonised pattern.

Under the base rate regime, banks were free to set their base rates using either the average or marginal cost of funds method. With most banks following the former, bulk of their deposits were unaffected by rate changes. This limited the cut in lending rates by banks.

The RBI sought to remove this hurdle through MCLR,under which banks have to calculate their cost of funds based on the latest rates offered on deposits or borrowings.

This ensured that changes in deposit rates immediately reflected on banks’ cost of funds. Hence, purely on math, banks have been forced to cut MCLR at a faster pace than base rate.

So far so good. But the MCLR structure created a new set of issues — legacy and varying reset periods (for lending rates).

Key issues

Old borrowers, who took loans prior to April 2016, continue to be charged interest on loans pegged to the base rate. While banks have cut MCLR sharply they have only tinkered with base rate over the past year.

Even if one had taken a loan under the MCLR framework, reduction in MCLR month on month has not benefited all borrowers. This is because , lending rates are reset only at intervals corresponding to the tenure of the MCLR.

External benchmark

By moving to an external benchmark, the RBI is looking to iron out some of these issues. As the rate will be market linked, policy rate changes will get reflected faster, leading to better transmission.

The key structural issue with earlier systems was that since banks source only a minuscule portion of their funds (1 per cent) from the repo window and rely significantly on longer term deposits, only about 50-60 per cent of banks’ funding gets re-priced. Hence a cut in repo rate does not immediately reduce their costs.

While moving to an external benchmark is expected to benefit borrowers in a falling rate cycle, the faster pace of transmission could pinch in a rising rate scenario.

Tough task for banks

Faster reset of loan rates (every quarter as indicated by the RBI) would mean that banks will have to create a portfolio of deposits and loans with a balanced mix across tenors such that the overall asset-liability gaps are managed well not only to reduce liquidity mismatches but also to mitigate earnings volatility.

One way could be to take short-term deposits. So, in a falling interest rate scenario, a bank’s deposits can get re-priced quickly and it can manage its loans getting re-priced quickly. But in such a scenario, the bank could run a liquidity gap.

The other way would be to develop floating rate deposits. The problem is that the best time to market such deposits will be in a rising rate scenario because customers will be more open to it. Till then, banks will have to make do with volatility on earnings.

One way to gauge the impact on earnings on account of holding assets and liabilities across different maturities or re-pricing dates is to look at the interest rate risk in the banking book, as disclosed under the Basel requirement by Indian banks.

For instance, for every 100 bps fall in interest rates, SBI’s earnings (net interest income) will fall by ₹4,663 crore. In general, interest rate risk to net interest income for Indian private and public sector banks have varied from about 2 per cent to 9 per cent.

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