Context

The Reserve Bank of India (RBI) is considering asking banks to link loans to an external benchmark such as the repo rate to improve transmission of policy rates and foster economic growth.

About

• In December 2018, RBI said that banks must set their interest rates for new loans against an external benchmark beginning 1 April.
• The rule was supposed to apply to all new retail loans and small business loans with floating rates from that date.
• The proposal, however, was opposed by bankers who wrote to the regulator citing their concerns.
• Thus in April, the linking to external benchmarks was postponed and RBI decided to discuss the proposal with the parties concerned before taking a decision on implementing it.
• Currently, banks price their loans based on their marginal cost of funds-based lending rate (MCLR).
• SBI had been linking the interest rate on its savings bank accounts as well as short-term loans to RBI’s repo rate since May 2019. Few other banks too have following the suit.

Significance

• Curbing inflation or stimulating growth by raising or lowering the cost of money is the key objective of monetary policy.
• But for a few years now, hikes or reductions in the repo rate by India’s Monetary Policy Committee have had only a marginal impact on the economy because of the partial transmission of these cuts by banks.
• Given that banks source only about 1 per cent of their funds from RBI’s repo window and the bulk from deposits from the public, they complain that they cannot slash their lending rates unless their deposit rates moderate.
• Linking savings account interest rates to the repo rate partly solves this problem by ensuring that banks’ cost of funds fall immediately after every repo rate cut, enabling lending rates to be pruned.

 Different types of policy rates and lending/deposit rates

Repo rate: It is the rate at which the central bank of a country (Reserve Bank of India in case of India) lends money to commercial banks in the event of any shortfall of funds. Repo rate is used by monetary authorities to control inflation.

Reverse repo rate: It is the rate at which the central bank of a country (Reserve Bank of India in case of India) borrows money from commercial banks within the country. It is a monetary policy instrument which can be used to control the money supply in the country.

Marginal standing facility (MSF): It is a window for banks to borrow from the Reserve Bank of India in an emergency situation when inter-bank liquidity dries up completely.

Bank rate: It is the rate charged by the central bank for lending funds to commercial banks.

Base rate: It is the minimum rate set by the Reserve Bank of India below which banks are not allowed to lend to its customers.

The marginal cost of funds-based lending rate (MCLR):

• It is the minimum interest rate that a bank can lend at. MCLR is a tenor-linked internal benchmark, which means the rate is determined internally by the bank depending on the period left for the repayment of a loan.
• MCLR is closely linked to the actual deposit rates and is calculated based on four components: the marginal cost of funds, negative carry on account of cash reserve ratio, operating costs and tenor premium.