External benchmark system improves monetary transmission: RBI Article

The introduction of the external benchmark system for lending and deposit rates has helped in improving the monetary transmission by banks, an RBI article said on Thursday.

The share of outstanding loans linked to external benchmarks has increased from as low as 2.4 per cent during September 2019 to 28.5 per cent during March 2021, said the article prepared by RBI officials.

"Over the years, the Reserve Bank's efforts in improving transmission to deposit and lending rates of banks have started to bear some fruits particularly with the introduction of the external benchmark system," it said.

The external benchmark system, it added, 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 benchmarks.

The RBI, it may be recalled, has asked banks to link all new floating rate personal or retail loans and floating rate loans to micro and small enterprises (MSEs) to the policy repo rate or 3-month T-bill rate or 6-month T-bill rate or any other benchmark market interest rate published by the Financial Benchmarks India Private Limited (FBIL) from October 1, 2019.

The adoption of external benchmark-based pricing of loans has strengthened market impulses for a quicker adjustment in deposit rates, the article said. Further, a combination of surplus liquidity conditions amidst weak credit demand conditions has enabled banks to lower their deposit rates.

The lowering of deposit rates has resulted in the decline in cost of funds for banks, prompting them to reduce their MCLRs (Marginal Cost of Funds based Lending Rate), and in turn their lending rates.

As per the article, the transmission of policy repo rate changes to deposit and lending rates of commercial banks has improved since the introduction of external benchmark-based pricing of loans.

The transmission showed further improvement since March 2020 on account of sizeable policy rate cuts, and persisting surplus liquidity conditions resulting from various system level as well as targeted measures introduced by the Reserve Bank.

In response to the cumulative reduction of policy repo rate by 250 basis points (bps), the 1-year median marginal cost of funds-based lending rate (MCLR) of banks declined by 155 bps during February 2019 to June 2021.

It further said the pass-through to deposit and lending rates is substantial for foreign banks during the external benchmark lending rate (EBLR) regime.

The public sector banks depend more on retail term deposits and face competition from alternative saving instruments like small savings, which constrains them from lowering deposit rates in sync with the policy repo rate.

Private sector banks have exhibited increased pass-through to lending and deposit rates compared to public sector banks.

"This uneven transmission across bank groups is partly explained by the fact that the share of outstanding loans linked to external benchmark is more for private banks as compared to PSBs," the article said.

The RBI said the views expressed in the article are those of the authors and do not represent the views of the Reserve Bank of India.