That RBI is deeply concerned about poor transmission of its monetary actions is well known. Bank credit is a major link in the transmission process in which commercial banks are the dominant intermediaries between savers and investors. If monetary policy signals fail to reach the ground through banks quickly enough, or remain incomplete, then aggregate demand is left inadequately moved. This could upset the central bank’s calculations about magnitude and timing of monetary policy effects, the most important being the estimated lag and uncertain, limited influence upon the business cycle. There could be other macroeconomic implications as well. Although Indian banks’ reactions to policy cues have long been lopsided, i.e., lesser, slower pass-through, the problem has magnified since 2014. Readers should recollect how banks refused to raise respective base rates even when RBI, under Raghuram Rajan, increased policy rates by 75 bps in September 2013 to January 2014. Similarly, base rates were lowered only partially (50-60bps average) in response to RBI’s cumulative 125bps easing through 2015. Subsequently, changes in lending rates have been differential due to shocks (demonetisation) and RBI’s directions.
This period also stands out for a structural shift in the policy rate (inflation-targeting framework, adoption of CPI as nominal anchor); a steady rise in bad assets, falling credit demand and resultant deterioration in banks’ health; a never-ending spate of stricter asset classification, recognition and provisioning norms, besides newer and stricter regulations. An increasing risk-aversion amongst public sector banks completes this picture.
The key limit to monetary transmission is structural, set by an overwhelming retail-deposit funding base of banks that compete with government run small-savings schemes, with a characteristic rigidity of deposit rates in the down-cycle. This, in turn, reflects savers’ preferences—skewed towards time deposits of over a year or more at fixed interest rates. It follows that banks can adjust but slowly on the downside—pare deposit rates for fresh deposits, wait for past contracts (at higher rates) to mature, and release space for fuller easing of lending rates for borrowers on the other side.
RBI has been trying to fix this weak transmission for a while.
Frustrated by banks’ failure to respond to its 50bps easing in January-March 2015, the central bank withdrew their discretion in choosing benchmark costs—average, marginal or blended—in December 2015, directed them to stick to marginal cost of funds (MCLR) henceforth, and restricted discretion in chargeable spread to just two elements (business strategy and credit risk). It was a radical departure from the past, when RBI has stopped short of micro-decisions and merely illustrated methodology to make interest rate setting uniform and transparent under the previous “Base Rate” regime. Less than two years down the line however, RBI is dissatisfied by outcomes of the MCLR regime, a tenure-linked rate of monthly frequency, which banks had to adopt in 2016. Banks reacted to marginal cost pricing by restricting pass-through to fresh loans/borrowers, keeping pre-MCLR loans (outstanding) at old base rates. A large chunk of borrowers thus felt no monetary relief. Illustratively, while the average MCLR tumbled 90 bps in the quarter after demonetisation, the average Base rate (old rules) declined 10 bps by contrast.
Given obvious differences in average and marginal cost pricing, the quicker pass through result under MCLR was predictable. And if the central bank had cared to reflect more deeply upon the line drawn by banks’ liability structures (time deposits contracted at older, higher rates), the old-new borrower distinctions made post-MCLR could easily have been foreseen too! It is clear as daylight where RBI should be focusing to strengthen monetary transmission—certainly not on directing banks to decide loan rates, which are impossible to delink from cost of funds. But RBI embarked upon another plumbing mission instead. In October 2017, its internal study group on the matter recommended eliminating internal benchmarks altogether, advocating external or market reference rates—choice of Treasury bill, CD or policy rate—and more restrictions upon banks’ spreads that it said should remain constant during a loan’s tenure.
Obvious again, these proposals weren’t well received by banks; market benchmarks being out of sync with their retail deposit funding base being the most important reason. Polite banks said the MCLR regime needed more time to settle down. Acknowledging this, on February 7, 2018, RBI announced harmonising of base rate calculations with MCLR from April this year; it underlined it was ‘not equalising the MCLR with Base rate’ but ‘harmonising’. Of course, the banks ‘agreed’ to ‘harmonise’ because in the distance they foresaw MCLRs rising; several had already raised deposit rates. So old, fixed-rate liabilities, maturing and otherwise, would be closer to rising MCLRs anyway, which would narrow the discrimination across new and old borrowers!
But the sluggish, slow response will return in the next phase of monetary easing. And the new outcome can once again be predicted: the same as before! Just a matter of time. Or cycles? It should have been clear to the central bank it is plumbing at the wrong pipe joint. Given banks’ funding structure, there is no way it can set the lending rate structure. If banks have to remain in business, they will factor in costs, vary risk premiums, no matter what kind of costs and formulas dictated by the central bank. RBI must stick to market principles, examine what obstructs smooth transmission. Attention to faults in market functioning, design and structures might serve its cause better. Can it build market structures similar to US, Europe and elsewhere if it wants market benchmarks and similar transmission effects? How can it shift Indian banks to non-retail deposit funds? Can it provide incentives, change regulations for banks to mobilise wholesale, bulk deposits in sufficient volumes to enable decent credit growth on the asset side? How can it change savers’ preferences as these are? How can it address the accompanying risks?
The irony here is that RBI, while flaunting its ambition to match global peers, as in adopting inflation targeting, is flouting the very basic tenets of market functioning, at the core of efficiency gains in intermediation. The central bank should know it is fighting an unwinnable battle despite mounting scale of interventions. Its own analyses record that in almost all countries it surveyed there was high elasticity of prime lending rates to deposit costs. That is the reason why RBI has been unable to fix the flow of its policy signals to the crucial credit market segment. Its actions to browbeat banks into submission can only increase uncertainty and distrust at a time when banks are under constant scrutiny for each of their past actions!
New Delhi-based economist