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Why rate cuts would trickle down slower

HYDERABAD:  With Friday’s 75 basis points (bps) repo rate cut, policy rates saw a reduction of 210 bps or 2.1 per cent in last one year. Even assuming that RBI puts a gun on banks’ heads to pass on Friday’s full 75 bps, borrowers, particularly existing customers, are unlikely to see a significant reduction in interest rates. For instance, between February 2019 and January 2020, though repo rate fell by 135 bps, for new borrowers, the weighted average lending rate fell by only 61 bps. It’s even worse for existing customers, as the reduction was a next to nothing, at 12 bps.

While ardent efforts such as the recently introduced repo-linked rates for home and auto loans make transmission faster, existing borrowers will have to continue living with slower rate reduction. Here are six reasons, which unwittingly impede faster transmission. The first and most important rate blocker is fixed deposits. Banks’ cost of funds depends on deposits and borrowings. But this cost is inflexible both due to the long maturity profile of deposits and their fixed interest rates. As on March 2019, more than half the deposits of commercial banks had tenors of 1-year and above; and for over 20 per cent, 5-year and above. Because they bear fixed interest rates, it makes banks’ outstanding liability profile insensitive to changes in policy rate, as per an RBI study.

Two, unlike deposits that are at fixed rates, over 75 per cent loans are on floating rates. Still rate transmission to floating loan rates is slow, again due to the long maturity profile of deposits. Also, when RBI raises policy rates, banks raise lending rates even without increasing deposit rates as demand for credit is usually strong. However, during a rate easing cycle, banks wait till deposits mature to renew them at lower rates, which in turn delays transmission. Three, although RBI deregulated savings account interest rates, banks hardly changed them (now at 3.25-3.5 per cent), which shows their preference not to use interest rates as a tool to alter cost of funds. Four: the legacy of base rate, a concept banks followed until April 2016 to calculate the cost of funds.

RBI has replaced it with MCLR, hoping it will ensure faster transmission. Though borrowers can switch over their base rate linked loans to MCLR, the shift has been slow as banks didn’t widely publicise the option to shift. Besides, banks charge a fee to shift, but won’t ensure immediate rate reduction as existing customers are forced to pay a higher spread than new ones. This makes the switch unattractive. As a result, banks continue to operate both MCLR and base rate systems, which makes transmission slower. Five: long periodicity of interest rate resets on floating rate loans. RBI data shows that as much as 76 per cent of floating rate MCLR loans are linked to MCLR of 1-year and above, while only 16 per cent are for tenor up to three months. This means loans linked to the 1-year MCLR are reset every year, unless banks decide otherwise.

This is the reason why your home loan resets, for instance, correct by 5-10-15 bps even when RBI reduces rates by 25-50 bps. Six: small savings schemes. Interest rates on small savings are linked to secondary market yields on G-Secs of comparable maturities. But data shows that rates don’t adjust in line with the movement of G-Sec yields, which change with repo rate. For instance, currently, small saving schemes rates are higher by 81-160 bps than G-Sec yields. That’s because in the absence of social security system and given that senior citizens depend on deposit earnings, government doesn’t prefer lowering rates beyond a threshold floor level. Consequently, this limits banks from lowering their deposit interest rates. Now, the good news. To override the factors mentioned above, RBI last October rolled out the external benchmark system (EBS) for all retail and SME loans.

Last month, the option was extended to even MSMEs. Here, rates are linked to repo rate, T-bills or CD rates to ensure faster rate transmission. How can we be sure? Consider the data. Against the cumulative reduction of 135 bps in repo rate between February 2019 and January 2020, the three-month yield on T-Bills fell by 144 bps. The three-month CD rate declined by 167 bps, while yield on three-month CPs issued by NBFCs and non-NBFCs fell by 190 and 140 bps respectively. Passing on policy rate changes is transparent under EBS; the only downside is, banks reset rates once a quarter.