Linking loan rates to external benchmark boosts RBI policy transmission

The Reserve Bank of India (RBI) has lowered policy repo rate by 250 basis points since February 2019. The rate easing cycle started much before the pandemic set in as the growth was showing signs of weakening already.

Lack of transmission of policy actions has been a long-standing issue in India’s financial market. The central bank experimented with several models to improve the transmission, but it seems they got it right this time. In response to each policy rate cut by the central bank, the bond market passed on the cuts almost immediately. Indian banks also lowered their rates, but not in the same quantum as the bond market. But the transmission was much improved in response to the pandemic.

One of the reasons why the transmission improved substantially was linking the lending rates to an external benchmark, such as a money market rate.

In response to the cumulative reduction of policy repo rate by 250 basis points, the one-year median marginal cost of funds-based lending rate (MCLR) of banks declined by 155 bps during February 2019 to June 2021.

“Transmission to lending rates has improved considerably in the current easing phase (up to May 2021) and more so since October 2019 when there has been a complete pass-through of repo rate cuts to the weighted average lending rate (WALR) on fresh rupee loans,” said the RBI in an article on its June bulletin released Thursday.