Rate cut by RBI – Part II

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 –
  1. Cost of funds (interest rates offered by banks on deposits)
  2. Operating expenses to run the bank.
  3. Minimum Rate of return ie margin or profit
  4. 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 –
  1. Operating Expenses
  2. Cost of maintaining CRR
  3. Marginal Cost of funds
     1. After considering interest rates offered on savings / current / term deposit accounts.
     2. Based on cost of borrowings - short term borrowing rate i.e repo rate & also on long-term borrowing rates.
     3. Return on Net-worth
  4. 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