Why the RBI is miffed with Banks

The RBI report on working of MCLR lists some adhoc practices followed by banks that have impeded monetary transmission

If there’s one puzzle that the Reserve Bank of India has been hell-bent on cracking for decades, it has been the issue of monetary transmission. Banks have almost always been unable to pass on the RBI’s rate action in its entirety. The recent tardiness by banks in cutting their benchmark lending rates — MCLR (a long lull after the demonetisation windfall) and the rigidity in the erstwhile base rate, has once again sparked the debate on the effectiveness of both rate systems. The ineffectiveness of the much touted MCLR structure has led the RBI back to the drawing board, looking at plausible external benchmark rates, in place of bank-specific benchmarks.

While a common market-linked benchmark can resolve some of the issues prevalent in the earlier structures, it offers only half the solution. The MCLR structure, purely on math, should have forced banks to respond quickly to policy actions. But adhoc practices followed by banks while fixing lending rates, has led to a wide set of transmission issues for new and old borrowers (under base rate).

The RBI’s report reviewing the working of MCLR/base rate, highlights some untenable practices (see table) followed by banks, which is a cause for concern.
Tweaking base rate

The base rate was to include the cost of funds, the negative carry in maintaining CRR and SLR, other unallocated overhead costs and a profit margin (return on net worth).

But despite the rigid structure in place, the issue of transmission persisted. Under base rate, banks were free to set their base rates using either the average or marginal cost of funds method. With most banks following the former method, bulk of their deposits are unaffected by rate changes. Hence banks not able to pass on the RBI’s rate action in its entirety is understandable.

But, going by the RBI’s report, structural reasons alone have not impeded transmission. The report flashes discrepancies in the way banks have been computing base rates, which hardly lends comfort. One major PSU bank, the report states, ignored fully the low cost CASA deposits while calculating its cost of funds. Another private and PSU bank, increased their net worth, to offset the sharp decline in cost of deposits to keep base rate unchanged. Given that profitability and hence return on equity has been under pressure for banks (even leading private banks) over the past three to four years, banks bumping up this component only highlights operational governance issues.
Slow migration to MCLR

In the absence of a sunset clause for base rate regime, banks have not been proactive in moving old borrowers from base rate to MCLR. Why? Simple, if banks had been aggressive in nudging old borrowers to move away from base rate structure, margins would have come under severe pressure, as lending rates under MCLR are 80-100 bps cheaper. Citing commercial or business sense, banks could still hope to wriggle out of their tardiness to move old borrowers to MCLR, but not passing on the full benefit of cheaper rate to a borrower who chooses to make the shift, is untenable.

The report indirectly refers to the many conditions banks laid down, when moving an old borrowers from base rate to MCLR. SBI for instance, offered two options for borrowers to make the shift. Under the first option, borrowers could switch, free of charge, but were locked into old rates for a year.

Even after a year, the spread charged to these borrowers worked out much higher than what new borrowers under MCLR would pay. Under the second option, SBI charged a fee (0.5 per cent of the loan outstanding) to make the switch immediately to the new MCLR rates. Hence in either case, customers have to bear the cost of making the shift. Banks have also made half-hearted attempt to educate customers on the switchover option to MCLR and the many complex nuances under the new MCLR structure.
The spread game

When the MCLR was introduced in April 2016, the RBI sought to make the spread charged by banks less discretionary by stipulating two broad components that banks should charge — business strategy and credit risk premium. It had also explicitly stated that the spread charged to an existing borrower should not be increased except on account of deterioration in the risk profile of the customer.

Despite these clearly stated directives, the banks have continued to charge spread arbitrarily under MCLR. In some banks, the RBI noted that there was no concept of a spread. Instead, banks used it as a balancing figure to derive at the desired lending rate.

One bank simply loaded a business strategy premium so as to match the MCLR with the existing base rate.

A look at specific actions by many banks, highlight the adhoc use of spread.

Bank of Baroda had pegged its one-year MCLR at 9.3 per cent in May last year, which was 35 basis points lower than its base rate then at 9.65 per cent. But by adding a strategic premium (0.25 per cent) to the MCLR, the bank had almost offset the wide difference between base rate and MCLR.

In January this year when SBI slashed its MCLR by a steep 90 basis points, it increased the spread on its home loan by a sizeable 40 basis points, offsetting some of the gain of lower rates. New borrowers (effective January 2017) had to pay a spread of 65 basis points over the one-year MCLR at 8 per cent. The resultant loan rate hence fell only 50 basis points.
Micromanaging

The RBI has now decided to move away from bank-specific benchmarks to a common external one. While this could ensure that banks don’t tweak internal variables to suit their needs, it only offers half the solution. Ensuring that banks actually price their loans to an external benchmark and review it periodically, would be a herculean task. The RBI’s attempts in the past to micromanage banks’ pricing actions, has only seen banks become more creative in finding ways to work around the system.

Under the BPLR rate system (introduced in 2003), the RBI left the methodology and computation to individual banks. It was found that banks seldom tweaked their BPLR rate to reflect the movement of policy rates and instead continued to lend at sub-PLR rates. In a bid to remove ambiguity, the RBI introduced a more rigid structure under base rate, which also failed to deliver.

The banks can again tinker with the mark-up (spread) charged over the new external benchmark, to ensure that the resultant lending rate moves to their bidding. Unless banks follow the laid down code to the letter, tweaking interest rate structures can do little to improve transmission.

Newer, complex structures add to borrowers’ woes, who have little know-how and help from banks to decode rate actions.

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