Base Rate, MCLR, and Monetary Transmission

The Base Rate is the interest rate below which Scheduled Commercial Banks (SCBs) will not lend money to their customers—similar it’s too prime lending rates (PLR) and benchmark prime lending rates (BPLR) in the past, and it’s essentially a floor rate of interest. On July 1, 2010, it replaced the previous BPLR concept.

The BPLR system (while the existing system was PLR), which was introduced in 2003, fell short of its original goal of increasing lending rate transparency. This was due to the fact that banks could lend below the BPLR under this system. This caused borrowers to haggle with banks, resulting in one borrower receiving a cheaper loan than the other, and blurred efforts to bring transparency to the lending industry. It was also difficult to assess the transmission of the Reserve Bank’s policy rates (i.e., repo rate, reverse repo rate, bank rate) to bank lending rates for the same reason. The Base Rate system aims to improve transparency in bank lending rates and enable better assessment of monetary policy transmission.

Following the RBI’s deregulation in 2010, banks are now able to set their own base rates. As a result, in practice, the base rate differs from one bank to the next due to differences in the banks’ operational costs. Banks were not permitted to lend at rates lower than their base rates. The banks’ base rate was between 8.15 and 9.40 percent in March 2020.

RBI took several new initiatives

The RBI took several new initiatives in the area of credit and monetary policy management in fiscal 2015-16, the most important of which are listed below:

• Transition to a bi-monthly monetary policy cycle.
• Recognition of the glide path for disinflation (recommendation of Urjit Patel Committee report implemented). Under it, the CPI (C) is used by the RBI as the “Headline Inflation” for monetary management.
• A Monetary Policy Framework has been put in place – an agreement in this regard was signed between the Government of India and the RBI in late February 2015. Under the framework, the RBI is to ‘target inflation at 4 percent with variations of 2 percent. It means, the ‘range of inflation’ is to be between 2 to 6 percent (of the CPI-C).
• Besides the existing repo route, term repos have been introduced for three sets of tenors-7, 14, and 28 days.
• The RBI is gradually restricting banks’ access to overnight liquidity (at the fixed repo rate) and encouraging them to rely more on term deposits. Banks were only allowed to borrow up to 1% of their NDTL from the Call Money Market-0.25% through repo and the remaining 0.75 percent through term repo by March 2016. This aims to improve policy impulse transmission across the interest rate spectrum while also ensuring loan market stability.
• In 2016-17, individuals were also allowed by the RBI to participate in the government security market (similar to the developed economies like the USA).

MCLR

From the 2016-17 fiscal year (which began on April 1, 2016), banks in the country have used a new methodology to calculate their lending rates. The RBI announced a new methodology in December 2015 called MCLR (Marginal Cost of Funds Based Lending Rate). The MCLR’s main characteristics are:

• it will be a tenor-linked internal benchmark, to be reset on annual basis.
• actual lending rates will be fixed by adding a spread to the MCLR.
• to be reviewed every month on a pre-announced date.
• existing borrowers will have the option to move to it.
• banks will continue to review and publish ‘Base Rate’ as hitherto.

‘For monetary transmission to occur, lending rates must be sensitive to the policy rate,’ according to the RBI. But this was no longer the case. The RBI cut the policy rate (repo rate) by 1.25 percentage points in 2015-16. Banks, on the other hand, reduced lending rates by a maximum of 0.6 percent. Banks have been computing their Base Rate using one of the three methods listed below:

1. the average cost of funds,
2. the marginal cost of funds, or
3. the blended cost of funds (liabilities).

As per the RBI, the MCLR will bring in the following benefits:

• transmission of policy rate into the lending rates of banks to improve;
• computation of the interest rates by banks will get more transparent;
• cost of loans will be fairer to the borrowers as well as the banks.
• it will help the banks to become more competitive and enhance their long-run value.

Bank MCLRs were in the range of 7.40-7.90 percent

Bank MCLRs were in the range of 7.40-7.90 percent by late March 2020. Because the MCLR did not produce the desired results (i.e., healthy monetary transmission), the RBI announced (in its 5th bi-monthly monetary policy statement of December 2018) that beginning in April 2019, all new floating loans extended by banks will be Benchmarked’ (i.e., linked to) one of the four RBI-prescribed ‘external’ benchmarks:

1. Repo rate,
2. 91-day Treasury Bill yield
3. 182-day Treasury Bill yield
4. Any other benchmark produced by the FBIL (Financial Benchmarks India Private Ltd).

It means that, unlike MCLR, actual lending rates will no longer be linked to the banks’ internal data, and banks will be forced to link the interest rates on new loans to an external, market-determined benchmark. After a brief period of transition, banks began using external benchmarks in October 2019. In the meantime, the process has not resulted in significantly improved monetary transmission.

Monetary Transmission

The allocation of funds from the financial system is heavily influenced by monetary policy. For this, banks’ lending rates must be sensitive to the central bank’s policy rates (i.e., repo, reverse repo, MSF, and bank rate)—a process known as monetary transmission.’ However, in recent years, the system has lacked a healthy monetary transmission. The RBI has been concerned about a general lack of monetary transmission in the financial system since 2015-16. The RBI has taken steps such as enforcing the MCLR and external benchmarks on banks for determining their lending rates until April 2020. However, monetary transmission has been weak22 in 2019 on all three counts: rate structure, credit quantity, and term structure:

Structure of Rates

Despite a 1.35 percent reduction in the repo rate, the Weighted Average Lending Rate (WALR) of scheduled commercial banks (SCBs) has remained unchanged in 2019—it was 10.40 percent in October 2019. (in January 2019, it was 10.38 percent). Between January and October 2019, the monetary transmission was slightly better in the case of new loans, with PSBs cutting interest by 0.47 percent and the private sector by 0.40 percent.

The credit spread (the difference between the repo rate and the WALR) was at its highest in a decade, with the WALR on outstanding SCB loans 5.25 percent higher than the repo rate. This suggests that the cut in the repo rate has not been passed on to bank lending rates in 2019.

Between January and October 2019, the savings deposit and term deposit growth rates both fell by 0.25 percent and 0.16 percent, respectively. The rate on small savings schemes like the Public Provident Fund appears to be a significant limiting factor (PPF). The PPF interest rate was 1.15 percent higher than the Weighted Average Term Deposit Rate (WATDR) at the end of October 2019, whereas there was no difference in 2014. It appears difficult to encourage term deposit growth without taking into account the interest offered on small savings schemes.

Term structure

The policy rate cut had an effect on short-term interest rates, which fell to 5.3 percent on 364-day Treasury bills by January 14, 2020. (from 6.3 percent of April 1, 2019). However, interest rates on long-term securities fell very slowly, with the 10-year G- Sec falling to 6.6 percent by January 14, 2020. (from 7.2 percent of April 1, 2019).

To lower the long-term fund’s interest rate, the RBI decided in December 2019 to buy long-term G-Sec (worth Rs. 10,000 crores) maturing in 2029 and sell short-term G-Sec worth the same amount maturing in 2020. (referred to by the experts as Operation Twist of the RBI). Following this action, the 10-year government bond interest rate fell by more than 0.35 percent until February 2020.

Credit Growth

Despite lower policy rates, credit growth in the economy has slowed in 2019-20—by December 20, 2019, it was at 7.1 percent, down from 12.9 percent in April 2019. The services sector and micro, small, and medium enterprises led to the decline in credit growth (MSMEs). During this time, MSMEs experienced a negative credit growth rate. 

Liquidity Management Framework

The RBI established a liquidity management framework (LMF) in 2014 to reduce volatility in the interbank call money market (CMM) and help banks manage their short-term capital needs. The LMF guidelines were as follows as of the RBI’s most recent amendment in February 2020:

• On any given day, the total repo borrowings of all banks combined cannot exceed 1% of the total NDTL of the banks (known as the upper repo borrowing ceiling). Individual banks can borrow up to 1% of their NDTL in repo operations, with 0.25 percent being overnight repo and the remaining 0.75 percent being term repo for 7/14/28 days.
• After exhausting the various repos, banks can borrow up to 1% of their NDTL for one day (known as overnight) from the RBI under the marginal standing facility (MSF).
• The RBI’s long-term repo, which began in February 2020, is an additional window above the repo operation’s 1% upper limit.

The RBI has been encouraging banks to think longer-term in their operations in order to bring more “stability” and better “interest rate signaling” to the loan market. The Basel III norms, which are aimed at ensuring that banks adhere to prudential standards, have also put a stop to the banking industry’s short-termism.