RBI Report on MCLR Interest rate: Or simply interest rate on loans by commercial banks – what we lost or would gain

We wish our readers a happy Deepavali.

We never had it so good to find that RBI would undertake whether commercial banks had really passed on any gains or losses to its customers whether on loans (various types) or deposits (yes, various types too) and pass any judgement after discussing with the banks. A common man gets bewildered that he gets a huge interest rate for loans taken for his business or even much smaller gain in deposits whenever change is in the air or some politician/industrialist/activist make some statements.

An internal Study Group was constituted by the Reserve Bank on July 24, 2017 to study the various aspects of the MCLR system from the perspective of improving the monetary transmission and exploring linking of the bank lending rates directly to market determined benchmarks. The constitution of the Study Group was announced in the Statement on Developmental and Regulatory Policies of the Reserve Bank of India on August 2, 2017. The Study Group submitted its report on September 25, 2017. The key findings emerging from the analysis undertaken by the Study Group and the recommendations made are set out below.

For any statistical oriented, economics or monetary theorist, the main report appears in the following web site: https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=878

For others, let me make its recommendations or study report in a simpleton’s language:

Before understanding the study, we may need to know the meaning of repo rate;

“Definition: Repo rate is the rate at which the central bank of a country (for India, RBI), lends its money to commercial banks in the event of shortfall of funds. Repo rate is invariably used by monetary authorities to control inflation.

Explanation: In case of inflation, RBI may increase the repo rate to make it as a disincentive for banks to borrow from the central bank. This ultimately causes reduction in money supply and thus controls increasing inflation. Similarly, fall in inflationary pressures, makes it easy for the central bank to increase the money supply by reducing the repo rate.

Repo and reverse repo rates form a part of the liquidity adjustment facility”.

Now the major report findings:

• The report consisted of 5 chapters and 9 annexures named as memorandum, meeting with the representatives of selected bank executives, net interest margins and monetary policy stance, an explanatory note on ax plot, IOSCO Principles for Benchmark, Possible candidates for benchmarks – Pros and Cons, Possible candidates for benchmarks – a summary assessment, FBIL Certificates of Deposits, FBIL Treasury bills. It is prepared by the best experts from various walks of life and with the best statistical, mathematical or monetary theory adopted by the best central banks in the world and copious references have been given.

Key Findings 

Monetary Transmission – the Base Rate and the MCLR Systems 

Let me give the gist of the findings made by the committee in my words for simple understanding: (original followed by my simple explanation)

“A review of banks’ deposit and lending rates undertaken by the Study Group indicates that the transmission from the changes in the policy repo rate has been slow and incomplete under both the base rate and the marginal cost of funds based lending rate (MCLR) systems. The monetary transmission has improved since November 2016 under the pressure of large surplus liquidity in the system post demonetization. While the transmission to interest rates on fresh loans was significant, it was muted to outstanding loans (base rate and MCLR). The transmission was also uneven across borrowing categories. Furthermore, the transmission to lending rates was asymmetric over monetary policy cycles – higher during the tightening phase and lower during the easing phase – irrespective of the interest rate system. For instance, the pass-through to outstanding loans from the repo rate was around 60 per cent during the tightening phase (July 2010 to March 2012), while it was less than 40 per cent during the subsequent easing phase (April 2012 to June 2013).”

• My explanation is that if the repo rate of RBI has been lowered by RBI, the banks have been slow in case of fall in repo rate but showed faster tightening of the rate by increasing it faster than the rate increased by RBI. Well, both under the base rate of RBI as well as the marginal cost of funds based lending rate (MCLR) the changes were uneven among loan categories.

Yes, the committee has seen the fact that the benefits due to borrowers or depositors failed to reach. Borrowers suffered enormously.

“An ad hoc, haphazard or unexplained methodology either to inflate the base rate or prevent the best rate from the falling cost of funds were noted from falling in line with the cost of funds. These ad hoc adjustments included, inter alia,

• inappropriate calculation of the cost of funds;
• no change in the base rate even as the cost of deposits declined significantly;
• 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
• 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.

Overall, monetary transmission has been impeded by following main factors:

• maturity mismatch and interest rate risk in the fixed rate deposits but floating rate loan profile of banks;
• rigidity in saving deposit interest rates;
• competition from other financial saving instruments; and (iv) deterioration in the health of the banking sector.
• A major factor that impeded transmission was the maturity profile of bank deposits. Deposits with maturity of one year and above constituted 53 per cent of banks’ total deposits at end- March 2016, most of which were at fixed rates of interest.
• Another source of weak transmission was rigidity in interest rates on banks’ saving deposits, which remained notoriously stubborn even as the policy repo rate and interest rates on term deposits moved in either direction.
• The third factor, which hindered monetary transmission was the competition that banks faced from other saving instruments.
• It appears that banks were reluctant to reduce interest rates sharply for fear of losing deposits to other financial saving instruments such as mutual funds and small saving schemes.”

My observations

Fixed rate of deposits carries a rate which does not change during the term of the deposits and hence does not match with floating rate loan profile. Frankly, foreign banks abroad, search for selling any loan the moment it is released if someone would buy. Match between loans and deposits is a natural phenomenon there.

For reasons historically felt, banks can’t mess up with interest rates in savings fund accounts. In India, its citizens have no social security benefits like abroad and hence the only savior has been some regular interest from saving instruments. The study notoriously fails to mention that when did the banks drastically made upward revision in savings fund interest?

It is equally debatable with the uncertain return from mutual funds, whether bankers were ever serious about serving deposit holders. Just sheer lack of decisive judgement about either depositors or borrowers constituted the uncertainties. Moreover, huge loans under considerations which are debatable in nature definitely contributed more non-performing assets which necessitated more provisioning. the liability side of banks’ balance sheet.

“Finally, empirical analysis suggests that the extent of responsiveness of interest earnings and interest expenses to the changes in the policy repo rate is broadly the same, making the net interest margins (NIMs) impervious to monetary policy changes.

 The deterioration in the health of the banking sector and the expected loan losses in credit portfolios induced large variability in spreads in pricing of assets, severely impacting monetary transmission as banks’ NIMs have remained broadly unchanged in the face of large stressed assets.

Thus, rigidities on the liability side such as longer-term maturity pattern of deposits with fixed interest rates, along with the expected loan losses on the asset side, have been reflected in higher pricing on the asset side, i.e., lending rates.”

My observations from the report:

• Further, I would mention that median spreads over MCLR over April – December 2016, January 2017, or over June 2017 were erratic and the difference between the private sector and public-sector banks were seen. Spreads were the largest in favor of private sector banks, followed by public sector banks and the least among them in case of foreign banks.
• Transfer of benefits to customers due to reduction in MCLR to lending rates for borrowers with a lag took 6 months for private sector banks, and more for public sector banks. (Yes, the benefits like less rate of interest on loans for borrowers due to less base rate or reduction by RBI, were denied. From the customer point of view, both the commercial banks and silent RBI supervisory role by its nominee directors looking the other way, caused making business in India, a tough one).

• “That many banks tended to charge the spreads over the MCLR arbitrarily is evident from a special study of select banks conducted by the Study Group.

• The key findings of the study are:

(i) Large reduction in MCLR was partly offset by some banks by a simultaneous increase in the spread in the form of business strategy premium ostensibly to reduce the pass-through to lending rates;

(ii) There was no documentation of the rationale for fixing business strategy premium for various sectors;

(iii) Many banks did not have a board approved policy for working out the components of spread charged to a customer;

(iv) Some banks did not have any methodology for computing the spread, which was merely treated as a residual arrived at by deducting the MCLR from the actual prevailing lending rate; and

(v)The credit risk element was not applied based on the credit rating of the borrower concerned, but on the historically observed probability of default (PD) and loss given default (LGD) of the credit portfolio/sector concerned.”

My observations:

• For a common man, it means no logic could be applied why the reduction in base rate did not help the borrower except that the banks showed a major chunk of the reduction as increase in business strategy premium: “why is it?” was never explained or any documentation kept. No principled note was also put up to the Board and RBI/Central Government Director nominees also kept their silence. Yes, for some banks Prevailing lending rate – MCLR as the residual which helped the banks not to reduce the borrowing rate of loans.

It is sad but true that the commercial banks under the term “autonomy” failed to help the banking borrowers though RBI through its bold report informed this fact to us.

Anyone would venture to ask, whether any recommendations were given by the committee appointed by RBI?      

Yes, the recommendations, flow as under:

• We have read from the study of the report of the RBI Committee that the base rate calculations are not uniform. It must be consistent among all banks. It must be definitely under the supervisory role by RBI or the Board at least.
• .” In the absence of any sunset clause on the base rate, banks have been quite slow in migrating their existing customers to the MCLR regime.
• Most of the base rate customers are retail/SME borrowers. Hence, the banking sector’s weak pass-through to the base rate is turning out to be deleterious to the retail/SME borrowers in an easy monetary cycle.
• To address this concern, besides immediate recalculation of base rates, banks may be advised to allow existing borrowers to migrate to the MCLR if they so choose to do without any conversion fee or any other charges for switchover on mutually agreed terms.
• However, after the adoption of an external benchmark from April 1, 2018 as recommended by the Study Group, banks may be advised to migrate all existing benchmark prime lending rate (BPLR)/base rate/MCLR borrowers to the new benchmark without any conversion fee or any other charges for switchover on mutually agreed terms within one year from the introduction of the external benchmark, i.e., by end-March 2019.
• The Study Group recommends that it should be made mandatory for banks to display prominently in each branch the base rate/MCLR (tenor-wise) and the weighted average lending rates on loans across sectors separately for loans linked to the base rate and the MCLR.
• The same information should also be hosted prominently on each bank’s website. The Reserve Bank could prescribe the format and the manner in which a minimum set of standardized data needs to be displayed in branches/hosted on banks’ websites.
• The Indian Banks’ Association (IBA), or any other agency considered appropriate by banks, could also disseminate bank-wise information on its website in the same manner in which each bank is required to disseminate information on its own website so as to facilitate easy comparison of lending rates across sectors and banks.
• The same system of dissemination of information on the benchmark and the weighted average lending rate could be followed under the external benchmark system recommended by the Study.”

What is the benchmark the above committee has been talking about in its voluminous and historic report?

An evaluation of 13 possible candidates

[weighted average call rate (WACR), collateralized borrowing and lending obligation (CBLO) rate, market repo rate, 14-day term repo rate, G-sec yields, T-Bill rate, certificates of deposit (CD) rate, Mumbai inter- bank outright rate (MIBOR), Mumbai inter-bank forward offer rate (MIFOR), overnight index swap (OIS) rate, Financial Benchmark India Ltd. (FBIL) CD rates, FBIL T-Bill rates and the Reserve Bank’s policy repo rate)]

suggests that no instrument in India meets all the requirements of an ideal benchmark. Each instrument has certain advantages as also limitations. After carefully analyzing the pros and cons of 13 possible candidates as a benchmark, the Study Group narrowed down its choice to three rates, viz., a risk-free curve involving T-Bill rates, the CD rates and the Reserve Bank’s policy repo rate. The T-Bill rate and the CD rate¹ were further assessed on three parameters, viz., (i) correlation with the policy rate; (ii) stability; and (iii) liquidity.

 The Study Group is of the view that the T-Bill rate, the CD rate and the Reserve Bank’s policy repo rate are better suited than other interest rates to serve the role of an external benchmark and the interest on loans must be linked to external benchmark rate to be prescribed by RBI and the spread over the benchmark rate needs to be fixed during the term of the loan. However, the banks would have the right to fix the spread.

Banks have also been advised to accept deposits on a float rate to be linked to the external bench mark rate.

Conclusion

Like yourself, I was also tempted by the topic handled by the committee, appointed by RBI and the mind-boggling references, mathematical calculations and candid discussions with 12 big banks who too gave their advice/recommendations to improve the working for the borrowers of the banks by the way of reduction in interest rates in tune with the intention of RBI or other factors which cause them. The recommendations in a nutshell, convey the feeling that banks need to keep an outside benchmark to be accepted by discussion with RBI/their Boards and also exhibit full information at website/branches/IBA or wherever customers may refer for information. No opaque medium to mislead the customers will help since India is in a hurry to globalize its operations at the cheapest cost of funds.

To become a developed nation, we need the topmost quality in Banks. Either they perform or learn from the world to improve.    

Any student of economics, statistics, banking or commerce must read the whole report of RBI to upgrade their skills/knowledge/widen the horizon of their wisdom.

Every banker must read the report for improving their performance. Hats off, to RBI for its meritorious report. We thank them for this huge task.