The share of outstanding loans linked to external benchmarks like the Repo rate introduced by the Reserve Bank of India rose significantly in the last two years, but opaque MCLR loans (or marginal cost of funds-based lending rate) continues to be the dominant rate structure for the banking industry, still hindering rate transmission.
Data collected from banks by the RBI suggests the share of outstanding loans linked to external benchmarks — mostly the Repo rate which is at four per cent — increased from as low as 2.4 per cent during September 2019 to 28.5 per cent during March 2021, contributing to significant improvement in transmission on the back of persisting surplus liquidity conditions.
According to an RBI report on ‘Monetary transmission in India’, legacy of internal benchmark linked loans (BPLR, base rate and MCLR) together comprised 71.5 per cent of outstanding floating rate rupee loans as at end March 2021, impeding the transmission. The share of loans linked to MCLR stood at 62.9 per cent as of March 2021. Only 8.6 per cent of floating rate rupee loans were still linked to the BPLR and base rate even though the Reserve Bank had moved to MCLR based regime over five years ago.
“The opacity in interest rate setting processes under internal benchmark regime hinders transmission to lending rates, although the EBLR regime is indirectly also leading to moderate improvement in transmission to MCLR based loan portfolio,” the RBI report said.
The RBI had made it mandatory for banks to link all new floating rate personal or retail loans and floating rate loans to MSMEs to an external benchmark like the Repo rate effective October 1, 2019. The MCLR method — considered as non-transparent — which was introduced in the Indian financial system by the RBI in 2016, replaced the base rate system that was introduced in 2010.
The central bank report says the information collected from banks suggests that most banks — 38 of the 58 banks which introduced external benchmark linked loans (out of a total of 71 banks that responded to a survey) — have adopted the Reserve Bank’s policy repo rate as the external benchmark for floating rate loans to the retail and MSME sectors in May 2021. These include 28 banks in the public and private sectors and five banks have adopted sector-specific benchmarks. “Data collected from banks suggest an increasing share of outstanding loans linked to external benchmarks – more so for foreign banks followed by the private sector banks,” it said.
The outstanding loans (linked to both fixed and floating interest rates) in personal and MSME segments accounted for 35 per cent of the outstanding loans as at end-March 2021. “Quarterly periodicity in re-setting interest rates for outstanding loans linked to external benchmark as against annual for MCLR linked loans has contributed to the improvement in pass-through to lending rates on outstanding loans,” it said.
The external benchmark system has incentivised banks to adjust their term as well as saving deposit rates as lending rates undergo frequent adjustments in line with the benchmark rates, to protect their net interest margins thus broadening the scope of transmission across sectors that are not even linked to external benchmark, the RBI said. Nonetheless, several impediments to transmission to lending rates persist, which call for resolution on a fast clip.
The report says that monetary transmission to all new loans sanctioned in respect of select sectors where new floating rate loans have been linked to the external benchmark registered substantial improvement. The weighted average lending rates (WALRs) of domestic banks in respect of fresh rupee loans on housing, vehicle and other personal loans declined significantly during October 2019-May 2021. “The decline was sharpest in the case of MSME loans (212 basis points) followed by other personal loans (164 bps). During the same period, the decline observed in WALR on fresh rupee loans for all sectors combined stood at 176 bps,” the report said.
As lending rates undergo frequent adjustments in accordance with the benchmark rate under EBLR regime, banks are incentivised to adjust their term as well as saving deposit rates to cushion their net interest margins. The median saving deposit rate for domestic banks which remained sticky at 3.5 per cent since October 2017, declined to 3 per cent in June 2020, the RBI said.
Higher interest rates offered by competing saving instruments such as small saving schemes and debt mutual fund schemes have impeded transmission especially during the easing cycle, the RBI said. The interest rates on small saving schemes, administered by the central government, in principle are set with a lag on a quarterly basis since April 2016 and are linked to the secondary market yields on G-secs of comparable maturities.
The interest rates on the various small savings instruments, after being lowered sharply during Q1 of 2020-21 in alignment with the formula-based rates, were left unchanged during the remaining quarters of 2020-21 and Q1, Q2 of 2021-22. The interest rates on various instruments were 46-179 bps higher than the formula-based rates for Q2 of 2021-22, with implications for monetary transmission.