In Fact: Dying hard, different loan rates for different people

It was reasoned that freedom to fix rates would lead to banks attracting funds that were otherwise not drawn into the banking system.

Written by Shaji Vikraman | Updated: January 12, 2017 12:38:31 am
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Two months after taking over as Governor of the Reserve Bank of India in the first week of February 1985, R N Malhotra and his Deputy Governor, Chakravarthi Rangarajan, decided to part de-regulate interest rates. Banks would have the freedom to determine deposit rates for maturities ranging from 15 days to less than 1 year, with a ceiling of 8%. By doing this, the central bank thought that banks would be able to raise more resources and widen their deposit base. Also, the share of short-term deposits — of maturities of 1 year or less in total deposits — was on the decline, and there was a distortion in short-term deposit rates. It was reasoned that freedom to fix rates would lead to banks attracting funds that were otherwise not drawn into the banking system. That was a time of preferential interest rates — as low as, say, 4% for farmers and small borrowers, when average deposit rates were well above 8%.

But the RBI perhaps hadn’t bargained for what followed after the move was announced on April 8. The next day, the Indian Banks Association, banks’ lobbying arm, released an indicative structure of interest for deposits of over 15 days but with a maturity of less than 1 year — negating RBI’s effort to nudge banks to determine rates on a competitive basis. The Finance Ministry, led by V P Singh in Rajiv Gandhi’s government, was quick to inform RBI of concerns that the freedom given to banks could lead to unhealthy competition to attract short-term deposits, impacting profits of state-owned lenders. The government suggested that the Deputy Governor (Rangarajan) ought to discuss the matter with the Finance Ministry, prompting the RBI to prepare a note saying profitability would not be hit, and over time, as more depositors moved to shorter maturities, the cost of funds for banks would decrease rather than increase. It also said that any scheme of de-regulation has an element of uncertainty initially. But the Ministry was apparently not convinced, and the Chief Economic Advisor prompted the central bank to roll back its decision. The move towards market determined rates was aborted, and rates were administered a month later, in May.

All this was a legacy of the 60s when the government started stipulating minimum rates of interest on loans disbursed by banks. That was to give way to a system of capping — or a maximum lending rate — in the late 60s, but the old system returned in 1970, the intention being to ensure credit flow to areas identified by the government and to keep its borrowing costs artificially low. All this led to a plethora of rates — and prompted the Sukhamoy Chakravarty Committee, which reviewed the working of the monetary system, to suggest that if the country’s savings were to be boosted, there should be flexibility in deposit rate changes. That was when, in 1986, a case was made for rationalising the interest rates structure, and for gradually reducing the number of concessional rates.

But it wasn’t until the mid-1990s that significant changes could take place. By linking interest rates to the size of loans, RBI was able to the reduce multiple rates and make the process simpler. Yet, differential rates of interest continued — such as providing loans to exporters at 4%, and interest rate subsidies for select sectors. Things started to change with the opening up of the economy in 1991 after the balance of payments crisis. With financial sector reforms, and as Rangarajan returned to the RBI from the Planning Commission, the dismantling of the administered interest rate structure and differential rates started. By then the report of the High Level Committee on the Financial System headed by former RBI Governor M Narasimham too had come in, and the RBI and government started introducing a host of changes — the concept of capital adequacy, income recognition, setting aside of funds against bad loans — in line with global norms.

In October 1994, as India announced it was moving towards current account convertibility, RBI freed lending rates for loans of over Rs 2 lakh, while protecting small borrowers. Banks were mandated to make the rates public. In July 1996, they were given the option to fix interest rates on local rupee deposit rates with a maturity of over 1 year too, signalling some sort of closure to financial repression.

Yet, after accepting that the system of a benchmark prime lending rate — introduced in 2003 in the interest of transparency — wasn’t working, the RBI moved to a new system of base rate in July 2010, making it mandatory for banks to price all rupee loans with reference to their base rate. Through all this, differential rates of interest continued — for crop loans, micro and small enterprises, and for primary agricultural societies, for example.

Over the years, despite reforms, successive governments have backed schemes offering credit to certain segments at rates below the benchmark — and providing for the difference in the Budget. On New Year’s Eve, Prime Minister Narendra Modi announced differential rates of interest on loans to segments such as housing. Home loans of up to Rs 9 lakh contracted in 2017 will be priced 4% lower, and those up to Rs 12 lakh, 3% lower, thanks to interest subvention. Similar support will be available for the neo middle and middle class in rural areas for loans of up to Rs 2 lakh for new housing or extension of housing.

Interestingly, in a speech on Wednesday in Gandhinagar, RBI Governor Urjit Patel said that while some government guarantees and limited subventions can help, steep interest rate subventions and large credit guarantees impede the optimal allocation of financial resources and increase moral hazards. The mandates for these must be narrow — and they must perforce be deployed judiciously within a regulatory framework suggested by the RBI.

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