Solutions to lack of transmission

Make it mandatory to link savings bank interest rate with an external benchmark. Banks should also make public details of how they calculate their MCLRs

The Reserve Bank of India (RBI) wants proper and quicker monetary transmission. That is, it wants the interest rates in the market (government securities, corporate bonds, fixed deposits (FD) and savings bank accounts with banks, lending rates of banks and others) to react in consonance with the policy rate (say, the repo rate).

Let’s understand with a simple example. Say, the RBI tracks only three rates – the 10-year government securities rate, 3-year bank FD rates and home loan rates.  If the RBI’s declared repo rate is 6.25 per cent, and the other three rates are:

• 10-year government securities – 7.50 per cent
• Three-year FD rates with banks – 7.00 per cent
• Home loan rate – 8.75 per cent

What RBI wants is that if they decide to drop/increase the repo rate by 25 basis points, the other three rates will need to be adjusted accordingly.

In practice, an equivalent drop in home loan rates isn’t possible because of two reasons: Existing FD rates are fixed for three years. Even for fresh FDs, the bank is unable to reduce rates because the rate of competing deposits from the post office or other popular small savings instruments continue to remain at higher levels. 

The government fixes these rates every quarter, irrespective of policy rates. Theoretically, these rates are linked to market-determined government securities rates (the first to react to the RBI’s policy rates). So, the rates should change equivalently to the RBI policy rates at the beginning of the next quarter. But small savings rates are politically sensitive. So, they do not come down even after a lag. Hence, banks that compete with these instruments are also unable to reduce the rates quickly or in an equivalent manner.

On the other hand, the entire system is geared to increase rates when the RBI increases policy rates since small savings rates go up only at the beginning of the next quarter, but banks would have already increased their deposit and loan rates. This is the rationale provided by banks to counter compliants. 

The RBI keeps making half-hearted attempts by asking banks to pass on interest rate cuts, and the State Bank of India has recently made an attempt to do so. But it is a drop in the ocean, especially as other banks may not follow suit.

There are two suggestions that could possibly assist in hastening transmission:

• The RBI could make it mandatory to link savings bank interest rates with an external benchmark. Unhappy depositors can always shift their money to an appropriate FD account if interest rates drop.
• The detailed calculation of MCLR should be made public by every bank and every month, so that the RBI gets the support of the entire borrowing class to check for any arbitrary changes in the methodology by banks.

This could be a halfway solution to this vexed problem of many decades.

The writer is a Sebi-registered investment advisor