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Linking lending rates to external benchmark the most effective transmission tool so far: RBI paper


The Reserve Bank of India’s mandate to link lending rates to an external benchmark have led to immediate spikes in interest rate paid by borrowers, making it by far the most effective transmission tool while the previous marginal cost of lending rate (MCLR) regime was as less satisfactory as the previous ones like base rate and benchmark prime lending rate, a research paper by Reserve Bank of India said.

In a bank-dependent economy, efficient monetary policy transmission to banks’ lending rates becomes the most crucial conduit for the successful implementation of monetary policy. RBI has changed the lending rate benchmark over time since the deregulation of lending rates in October 1994.

“Transmission during the MCLR regime was far from satisfactory,” said RBI’s research paper, necessitating the introduction of external benchmark-based pricing of loans for the personal loans and micro & small enterprises, effective October 1, 2019, and for medium enterprises from April 1, 2020.

Effective transmission requires fulfillment of various pre-conditions such as transparency in the process of pricing of loans by banks. Since October 1994 when RBI deregulated interest rates, the banking regulator has also been stipulating the adoption of a specific benchmark for pricing of loans by banks.

RBI mandated an internal benchmark – prime lending rate (PLR) — in October 1994. In April 2003, the central bank supplanted PLR with the benchmark PLR (BPLR), which was followed by the base rate in July 2010 and MCLR in April 2016.

“None of these benchmarks met the expectations,” said the paper, authored by Sadhan Kumar Chattopadhyay and Arghya Kusum Mitra.

April 2004 and July 2019, the monetary transmission was subject to variable lags across internal benchmark regimes and policy cycles. “Transmission to lending rates was usually – though not always – higher during the tightening cycle than the easing cycle regardless of the regimes,” they said.

Transmission during MCLR regime was muted during April-October 2016 but post demonetisation, it gathered pace aided by the surfeit of liquidity, which encouraged domestic banks to reduce their saving deposit rates for the first time since the deregulation of saving deposit rates in October 2011.

The reduced cost of funds prompted banks to reduce their MCLRs sharply. “Shorn of the one-off demonetisation impact on the cost of funds, the performance of MCLR regime on transmission was not very satisfactory,” the paper said.


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