Why in news?
While cutting the repo rate by 25 basis points, RBI called on banks to reduce rates for existing borrowers too.
How does the repo rate work?
- Repo rate is the interest rate at which the RBI lends money to commercial banks.
- It is a monetary policy instrument which can be used to control the money supply and thereby inflation.
- By reduction the rate, borrowing becomes cheaper for the banks.
- So the banks will end up with more money which can be lent to its customers.
- More money with the public will result in higher economic activity thus pushing the growth of the country.
What do banks do to subvert this?
- Base rate is the minimum rate set by the Reserve Bank of India below which banks are not allowed to lend to its customers.
- Banks calculate the lending rates to its customers based on the base rate.
- The main components of base rate system are –
- Cost of funds (interest rates offered by banks on deposits)
- Operating expenses to run the bank.
- Minimum Rate of return ie margin or profit
- Cost of maintaining CRR
- It does not consider ‘repo rate’ in their calculations. So the effect of Repo rate is not reflected in this.
- Banks often does not reduce their lending rate even after the reduction of repo rate, to increase their profits.
How was it rectified?
- In April 2016 MCLR was introduced.
- The components of MCLR include –
- Operating Expenses
- Cost of maintaining CRR
- Marginal Cost of funds
- After considering interest rates offered on savings / current / term deposit accounts.
- Based on cost of borrowings - short term borrowing rate i.e repo rate & also on long-term borrowing rates.
- Return on Net-worth
- Tenor Premium - based on the loan tenure & commitments.
- So any change in repo rate will be reflected in lending rates too.
What is the current problem?
- The central bank has reduced the repo rate by 200 bps since January 2015.
- While banks cut the marginal cost of funds based lending rate (MCLR) by up to 90 bps, the reduction in the base rate was much lower.
- MCLR has been operational only from April 2016.
- So a large proportion of loans are still linked to the base rate and such borrowers have not benefited to the extent of the new borrowers.
- The difference between the base rate and MCLR, for some banks, is as high as 90-100 bps.
- The commercial banks also have a tendency to reduce interest rates only for prospective customers in order to push new business.
- They reduce rates for segments where competition was high as in the case of home loans and personal loans.
- So the RBI pushed the lenders to pass on lower loan costs to borrowers who had not received the full benefit of the reductions in the policy rate.
Source: The Hindu
