Even after two rounds of repo rate cuts of 25 basis points (bps) each by the RBI since January, most banks are yet to lower their lending rates. The few that have done so have reduced between 10 and 25 bps, raising questions on the effectiveness of “monetary transmission” or the response of banks to policy rate cuts by the RBI. True, banks have in the past been prompt in passing on any increase in the repo rate to borrowers; the lack of transmission is greater when it comes to lowering interest rates. But such behaviour in the current situation may partly have to do with the high level of non-performing assets on their books. The fact that banks are not earning any income from their pile of bad debts means a general reluctance to reduce rates on both existing good loans and fresh advances.
This isn’t a happy state of affairs for either the RBI or the government, not to speak of borrowers. For effective monetary transmission, the RBI would have to resort to really sharp policy rate cuts — which it clearly isn’t keen on. The government’s frustration is mirrored in Finance Minister Arun Jaitley’s recent statement that he “expects” banks to cut interest rates though “we do not put pressure on them”. Moral suasion, in any case, may not be the most desirable route to take.
Instead, the time may have come to review the very concept of the “base rate” that each bank is mandated to declare — below which it cannot lend. Moreover, the base rate is to be fixed according to the bank’s average cost of deposits, the negative “carry” on account of statutory preemptions (SLR/CRR), unallocated overheads and desired return on net worth. This, by itself, imparts a certain inflexibility to the monetary “pass-through” mechanism, apart from smacking of the old regime of administered interest rates. The need to announce a base rate and fix it on a rigid formula makes it difficult for banks to lend at low rates. This, even when it may be commercially expedient, taking into account overall liquidity positions or lendable surpluses in the short term. Nor do banks have the freedom to lend at below cost to good-quality customers and recoup this through charging more from other borrowers. As a result, we are seeing top corporates today borrowing cheaper overseas and banks here unable to compete. A better way to ensure both transparency and effective monetary transmission is to let each bank simply declare its lending rate to first-class borrowers, sans any predetermined formula. This rate, when benchmarked to the daily Mumbai interbank offered rate or MIBOR, will show where each bank stands.