Like many RBI reports, the Report of the Internal Study Group (ISG) on the transmission of Policy Rate changes via the Marginal Cost of Funds Based Lending Rate (MCLR) system is comprehensive, yet precise, and reflects academic rigour. However, the acceptability of its recommendations by the practising commercial bankers seems limited, as their behaviour is shaped increasingly by ground-level realities, which vary across activities, locations, borrower-types, etc, and are largely unstructured, illogical and prone to influences, and hence difficult to capture and rationalise even with the aid of modern analytics techniques. Being an ‘internal’ report, it is one-sided; it forcefully defends the regulator’s arguments, which have been made time and again, and it also doesn’t take into account the dilemmas that commercial banks, especially PSBs, encounter at the operating levels while translating periodic policy rate changes into MCLRs. The disharmony sounds perplexing, since ISG had reportedly carried out discussions with a cross-section of bankers from public and private sectors, and foreign banks operating in India.
However, only five relatively large PSBs were consulted, despite, in a softening interest rate regime, it is the relatively small or weak banks whose probability of experiencing profit squeeze and eventually becoming vulnerable, while transmitting policy rate reductions, becomes higher. The issue of transmission has become glaringly debatable, with the NPA imbroglio turning out to be intractable with little immediate solution in sight. Also, inadequate credit dispensation by banks is being singled out as growth impeder, inappropriately though. Contrastingly, credit and interest rate don’t constitute the facilitators of growth; the deficient supply of many other critical inputs thwarts growth in more significant ways, which is widely acknowledged too. At the root of the transmission issue lies what we call ‘goal asymmetry’, which remains unaddressed in the ISG report.
This means that while for RBI the macro objective of price stability and growth constitute the fundamental concern, for a bank the immediate objective is micro, i.e. earning adequate net profit year-on-year so that it remains safe and sound, and is able to uninterruptedly (a) continue its classical financial intermediation function, (b) reward its shareholders, including the central government and institutions (domestic and foreign) principally in terms of higher dividend payout and valuation at stock markets, (c) support the government borrowing programme, and (d) pay wages and salaries to its employees. A similar asymmetry is discerned when the government expects RBI to reduce repo rates, but it doesn’t happen. Against the backdrop of limited functional autonomy and operational flexibility, the pricing power of PSBs for both liability and asset products as also ancillary services is, by default, fraught with risks with adverse systemic implications. The fulcrum of interest rates is weakened by cross-subsidisation among products and services as well as implementation of nationwide programmes like PMJDY and demonetisation.
Today, banks have turned ‘once bitten twice shy’, especially towards wholesale loans. No doubt, the retail loan book is growing well, but with ominous possible consequences on account of unsustainable household debt in an increasing number of cases. In view of this, maintaining a respectable ‘spread’ and ‘burden’ has become imperative for a bank. To protect the ‘spread’, if it reduces its lending rates, it will also have to reduce pari passu the deposit rates and many have done it, which, of late, has led depositors, especially the ‘sophisticated’ few, to migrate to market-related products to compensate for unremunerative post-tax real return on deposits. However, entry into market necessitates larger financial and emotional risk appetite, which the common depositors lack, and banks are aware of it and care for it. Thus, many banks suo motu have desisted lowering their deposit rates below a certain low.
As for ‘burden’, with increasing electronic transactions, banks’ other income sources are drying up (the Centre is proposing to have its own payment systems to bypass banks and credit bank accounts of DBT beneficiaries, denying the commission being earned by commercial banks) as against operating expenses (comprising significantly wages and salaries which are susceptible to periodic hikes too) being highly inelastic. Besides, service charges by banks are quasi-regulated. In such circumstances, reduced transfer from net profit to ‘reserves & surplus’, or drawing therefrom would only undermine the intrinsic strength. Further, bank failures are evidenced to be more contagious and deleterious than the real sector enterprises. Ceteris paribus, it is arguable whether the proposed linkage of MCLR with an external benchmark would help banks overcome the hurdles. It is also not clear from the report how the external benchmark would factor in in the IRAC norms and other prudential regulations that are changed from time to time with definite, explicit impact on net profit.
Although the three preferred benchmarks have been found to be stable, the financial markets and rates can’t always be quarantined from perceptions, sentiments and judgements of market participants besides the external environment, and so their vulnerability to fluctuations remains an open-ended question. In such occurrences, how frequently and fast MCLRs would need to change or be managed? The report doesn’t address these imponderables. If RBI starts influencing, directly or indirectly, the ‘business strategy premium’, then it would tantamount to regulation through backdoor. PSBs are considerably diversified—starting from their origin to current business profile. And that a ‘one benchmark fits all’ approach would address the diversity seems contentious. Also, many small or weak PSBs are ‘free riders’; they follow what their stronger counterparts do. In an aggressively low interest rate regime, the latter can weather the headwinds, but the former can jeopardise systemic stability.
The ISG report gives an impression that banks or markets operate in silos. For example, as far as deposits are concerned, banks compete with small savings whose rates are benchmarked to G-Sec yields. If a benchmark for determining MCLR is introduced, deposit mobilisation by banks will have to track this additional benchmark because lending and deposit rates are synergistic. Does it not sound intricate and confusing? Moreover, on the investments side, they are benchmarked to several money market rates. Against these arguments, it would be more appropriate if banks are left to determine their own internal benchmarks. Some of the ‘enablers’ for banks to respond more appropriately to policy rate changes include: (a) resolving the lingering stressed assets issue with alacrity and keeping the system future-ready always; (b) bringing in system-wide changes instead of addressing individual bank problems in ad hoc manner; (c) abolition of the so-called ‘dual control’ as was recommended by the Narasimham Committee (1991); (d) according banks increased functional autonomy and operational flexibility; (e) minimising political and bureaucratic interference in banks’ decision-making process; (f) weeding out the zombie banks fast to spruce up systemic efficiency; and (g) making interest on FDs tax-free.
In the subjectivity world of decision-making in banks, it would be unproductive to be in quest of 100% objectivity or perfection. Allowing banks to determine their own benchmarks with appropriate human input, processes, and relevant and correct data can unleash healthy competition, leading to a stronger system. Ultimately, in the medium-term, one may think of segregating the wholesale and retail operations of especially the big banks with different benchmark rates.
–Ashwini Mehra & Manas Das