RBI vs. ROB (Rest of the Banks)

RBI on 4^th Oct 2017 released a report of the Internal Study Group, to Review the Working of the Marginal Cost of Funds Based Lending Rate System (MCLR). This rate is applicable to borrowers when they apply for loan. RBI through the banking system (I will call them - Rest of Banks (ROB)) manages the transmission of interest rate policy.

The Executive summary started off with a very damning note on monetary policy transmission by the banks (under “Key findings”). The extract below is an indication that the committee was categorical in ascribing malafide intention, and was short of using the word “cheating”, in the manner in which, the Banks avoided policy rates transmission, to its respective customers.

Extract from report -Key findings 

“Analysis conducted by the Study Group suggests that banks deviated in an ad hoc manner from the specified methodologies for calculating the base rate and the MCLR, to either inflate the base rate or prevent the base rate from falling in line with the cost of funds.

These ad hoc adjustments included, inter alia,

(i)            inappropriate calculation of the cost of funds;

(ii)           no change in the base rate even as the cost of deposits declined significantly;

(iii)          sharp increase in the return on net worth out of tune with past track record or future prospects to offset the impact of reduction in the cost of deposits on the lending rate; and

(iv)         Inclusion of new components in the base rate formula to adjust the rate to a desired level. The slow transmission to the base rate loan portfolio was further accentuated by the long (annual) reset periods”. (para 3 of executive summary) -       End of extract

The report cited that the major factor that impeded the transmission, was the large portion of deposits with fixed rates and 1 year and above maturity (53% of deposits held were in this category). While this was in the liability side, the other factor was Banks were competing with  savings instruments like mutual funds and small savings schemes and hence were reluctant to reduce the interest rates (would have led to loss of deposits, though tax adjusted returns are much lower)

The other factor quoted for non-transmission is large NPA problem that the banks are facing and the banks thought it prudent to cover themselves with unexpected loan losses in credit portfolios by retaining higher spreads.

The report indicated two key elements on the transmission of spread changes

1.    The report dwelt that there was a “lag in spreads changes” both in private and public banks. While the spread in private banks was around 6 months, the public banks did not change the spreads even after 6 months.

2.    The second aspect was that for the existing/outstanding loan, the transmission was lower than for new loans. This means, the existing borrowers continued to pay higher interest rates than what RBI’s monetary policy rates indicated (since mostly the report covered period when the interest rates were coming down).

Finally, the report cites, how banks tended to charge the spreads over Marginal Cost of Funds Based Lending Rate (MCLR) arbitrarily (evidence gathered from a special study of select banks).

These arbitrary actions were

1)    Large reduction in MCLR (that could have led to lower interest rates) was partly offset by simultaneous  increase in spreads in the form of  “business strategy premium”, ostensibly to reduce  the pass through to lending rates

2)    There were no documentation of the rationale for fixing business strategy premium for various sectors (sector-wise adjustment, without adequate documentation is a clear indication that the banks did not want the RBI or for that matter anybody else to see what and how this was calculated)

3)    Many of the banks cited, did not get these premiums approved its Board

4)    Some of the banks, just arrived at this premium as the “residual” by subtracting the existing rate from the arrived MCLR, thus in fact retaining the rates (hence no transmission)

From the above its clear and unambiguous that Banks in India have played a big role in thwarting transmitting policy rates to the customers through erroneous as well as with malafide intentions. Moreover, indication of opaqueness, lack of internal governance and rank opportunism is revealed.

This seems very similar to the LIBOR gate (rate manipulation) that saw few unscrupulous bankers decide LIBOR rates to suit their needs than through normal economic considerations.

Recommendations by study group-

1.    Banks to be advised to recalculate the base rate immediately by removing/adjusting arbitrary and discretionary components added to the formula. The intent is correct, but who and how this will be executed and who in RBI will take responsibility and how much time will the banks be given to make this changes is not clear. Without recommendation that specifies deadline, this seems improbable at this moment

2.    RBI had not specified sunset clause for Bank rate (the earlier avatar of MCLR) leading to very slow migration to MCLR by banks (contrast this with GST migration). The study group has recommended that Banks be asked to migrate the existing customers to MCLR without paying any conversion fee or switchover fee. Banks have been given time between April18 till March 2019.

3.     Banks are recommended to show in each branch and their sites, the MCLR rate for each tenor across various industries. They have also recommended that IBA or such other organization may be asked to show the rates across various banks for easy comparison.

4.    The study group recommended that both the Bank rate and MCLR have not been effective in transmitting the policy rates to the final customer/in the market, and has given alternative “external benchmark rates” that may be adopted after taking into account feedback and suggestion from the stakeholders. Out of possible 13 alternatives, the study group has identified 3 as benchmark rates. These are

a.    a risk-free curve involving T-Bill rates

b.    CD (Certificates of Deposit) rates

c.    Reserve Bank’s policy repo rate         

RBI is expected to take action on the above recommendation.

In the end, the issue is not which benchmark rate will RBI use to monitor and transmit its policy direction, but how will it ensure that Banks do follow on and pass it the customers in reasonable time, as it intended to and do not rob the customers. With the expected increase in accessing formal banking (JAM) by retail customers, integration of large no of formal SME into financial system and opening up of digital banking (payments bank, P2P lending, etc), RBI’s role is cut out in its most important function of setting the right interest rate and transmission into the financial system and for, RBI this is “too big to fail”.

Annexure:

 Key charts that support the issues surrounding transmission of policy rates

 

How to read the above tables.

1.    Repo rate – Policy rate reduction by RBI (reduction indicated in negative).

2.    Changes in Base rate (the earlier avatar of MCLR (prior to April’16) against the repo rate is lower and with wide margins.

3.    Compare this with the reduction in Deposit rates (liabilities side) and WALR –outstanding/fresh rupee loan.

4.    The transmission in outstanding loan is far lower than fresh loans

5.    Impact of demonetization seems to be positive in driving transmission of policy rates.

6.    The higher cut in the MCR post demonetizations is due to high liquidity (deposit of high value note) and weak credit demand

7.    Private banks transmission was better than public sector banks

8.    In the sector-wise lending rates, the personal vehicle, housing and agri loans were least adjusted while, export credit loans and large corporates loan, the transmission was higher. The bias towards large corporates is very visible, while retail loans have not benefitted (in the reducing interest regime)