Why don't banks pass on rate cut benefits to customers?

The largest contributing factor to such practice is the pile of bad assets. Banks do not earn any interest on bad loans and, on top of that, they need to provide for them. So, the good borrowers end up subsidising the bad borrowers, says Tamal Bandyopadhyay.

Illustration: Dominic Xavier/Rediff.com

When it comes to monetary policy, a career bureaucrat could be more innovative than an economist.

Reserve Bank of India governor Shaktikanta Das has proved that.

After taking three baby steps since February, when the rate cutting cycle started, he changed track recently: No more baby steps (25 basis points or bps rate cut); not a giant step (50 bps) either.

He followed the “golden mean” of the Buddhist philosophy -- a 35 bps rate cut, bringing in the policy rate to 5.4 per cent.

Indeed, it was the decision of the rate setting body of the Indian central bank, the Monetary Policy Committee, but Das has been advocating such odd cuts for months now, as there is nothing sacrosanct about a 25 or 50 bps move that traditionally the RBI has been opting for.

For him, 25 bps is too low and 50 bps is too high -- a 35 bps cut is appropriate, at this juncture.

If the same trend continues, the next rate cut could be 15 bps or even 40 bps, depending on economic conditions.

The Chinese central bank typically moves rates in multiples of 9 bps; for the European Central Bank, it is 10 bps; and the central bank of Taiwan, 12.5 bps.

In the Das regime, the RBI will probably tread on the path of multiples of 5 bps.

One school of thought is that the Indian central bank has now been undoing what it had done in the past -- too much of tightening -- and more rate cuts should be on the table.

But you could also say that the RBI has done enough since February and it cannot do the heavylifting of a slowing Asia’s third largest economy alone.

Soon, the law of diminishing marginal utility will catch up with it.

In other words, with every successive rate cut, the impact will wane.

Yes, that could be true for the market rates, but the credit story is different because the banking community is shy of transmitting the rate cuts.

Within hours of the latest round of rate cut, State Bank of India, nation’s largest lender, rushed to cut its MCLR or the marginal cost of fund-based lending rate, by 15 basis points, roughly passing on 40 per cent of the benefit to its borrowers.

A cumulative rate reduction of 75 bps since February and a change in the policy stance have led to 102 bps drop in the 10-year government bond yield but a feeble 29 bps cut in the bank loan rates.

The government is the biggest beneficiary of the rate cutting cycle as its borrowing cost has gone down substantially but the banking system has cold shouldered corporate India and retail borrowers.

You can lead a horse to water but you can’t make it drink.

How does one ensure monetary policy transmission?

Why doesn’t the banking system pass on the benefit of low interest rates to the borrowers?

One way of looking at it is the bankers are lazy and greedy.

They are always fast in cutting down the deposit rates but slow in paring the loan rates.

Also, the benefit of lower loan rates is often given to the new borrowers while the old borrowers continue to pay high rates.

This happens particularly in the retail loan segment.

The largest contributing factor to such practices is the pile of bad assets.

Banks do not earn any interest on bad loans and, on top of that, they need to provide for them.

So, the good borrowers end up subsidising the bad borrowers.

But this is an oversimplification of the ground realities.

Even after the banks cut their deposit rates, the new rates are applicable only to incremental deposits while almost the entire loan book gets re-priced immediately, following any loan rate cut.

Also, the rate cut typically does not impact the banks’ current accounts (on which they do not pay any interest) and savings accounts (most large banks have been paying 3.5-4 per cent interest on such accounts).

So, the lowering of rate does not impact the cost of the entire deposit portfolio of the banks.

The transmission of the policy rates needs to be looked into both for loans as well as deposits – -and not for loans alone.

The only way to pare the deposit cost instantly is to have a substantial floating deposit base.

Either the banks need to make the floating rate deposits attractive to entice savers or the regulator can explore an idea of making a part of the deposits linked to floating rates mandatory.

Media reports suggest a few banks are planning to make the RBI policy rate as the benchmark rate in place of MCLR which has been under the scrutiny of the regulator.

The Indian banking system's search for an ideal benchmark for loan rates has been on for 25 years.

First, there was PLR or prime lending rate, introduced in October 1994.

It was the rate at which banks used to lend to their top-rated clients but it had no relation to their cost of funds.

Some time early this century, the PLR was replaced by BPLR or benchmark PLR, which was supposed to factor in the actual cost of funds, operating expenses and regulatory requirements, provision for bad loans as well as profit margin.

Then came the base rate (in July 2010) -- supposedly more transparent and fairer to small and medium enterprises that had for so long been subsidising top-rated corporate borrowers.

But that did not happen. So MCLR came in but again no one was happy and the RBI was planning to introduce a new benchmark from April -- a move Das has kept on hold.

Unlike in the developed countries, where banks raise money from the market to lend, in India, deposits and capital are the primary sources of lending.

So, the key to bringing down the loan rates is the cost of deposits.

We need to look for two benchmarks -- one for loans and another for deposits.

In isolation, a benchmark for loan alone will never work.

If we remain obsessed with monetary transmission for loans alone, banks may end up robbing Peter to pay Paul.

Tamal Bandyopadhyay, a consulting editor with Business Standard, is an author and senior adviser to Jana Small Finance Bank Ltd. His latest book, HDFC Bank 2.0: From Dawn to Digital, was released recently.