Monetary Transmission

Monetary Transmission

Subject: Economy

Context: Data collected from banks by the RBI suggests the share of outstanding loans linked to external benchmarks — mostly the repo rate which is at 4 per cent — increased from as low as 2.4 per cent during September 2019 to 28.5 per cent during March 2021

Concept:

MCLR

• The Marginal Cost of Fund based Lending Rate refers to the minimum interest rate a bank must charge for lending. The bank cannot grant any loan below that rate, except in certain cases permitted by the Reserve Bank of India (RBI).
• The MCLR is determined by the current cost of funds, in contrast to the base rate, which is governed by the average cost of funds. The MCLR was introduced by the RBI because rates based on this system are more receptive to the changes in the policy rates. This also ensures that the country’s monetary policy is implemented effectively across all spheres.
• As a result, the MCLR ensures that the lending rates of banks reflect the policy rates. Moreover, it also provides transparency in the procedure followed by banks to arrive at interest rates on advances. Every month, banks may publish the internal benchmark (MCLR) for overnight, one-month, three-month, and six-month and one year maturities.
• The MCLR method considered is a non-transparent which was introduced in the Indian financial system by the RBI in 2016, replaced the base rate system that was introduced in 2010.

Factors that Determine the MCLR

• Marginal Cost of Funds
• Operating Costs.
• Cost of Carry in the Cash Reserve Ratio (CRR
• Tenor Premium.

Repo rate: It is the rate at which the central bank of a country (Reserve Bank of India in case of India) lends money to commercial banks in the event of any shortfall of funds. Repo rate is used by monetary authorities to control inflation.

Reverse repo rate: It is the rate at which the central bank of a country (Reserve Bank of India in case of India) borrows money from commercial banks within the country. It is a monetary policy instrument which can be used to control the money supply in the country

Transmission of lending rate (internal vs external)

• The external benchmark system has incentivised banks to adjust their term as well as saving deposit rates as lending rates undergo frequent adjustments in line with the benchmark rates, to protect their net interest margins thus broadening the scope of transmission across sectors that are not even linked to external benchmark.
• The share of outstanding loans linked to external benchmarks like the Repo rate introduced by the Reserve Bank of India rose significantly in the last two years, but opaque MCLR loans (or marginal cost of funds-based lending rate) continues to be the dominant rate structure for the banking industry, still hindering rate transmission.
• The opacity in interest rate setting processes under internal benchmark regime hinders transmission to lending rates
• Most banks 38 of the 58 banks which introduced external benchmark linked loans have adopted the Reserve Bank’s policy repo rate as the external benchmark for floating rate loans to the retail and MSME.
• The RBI had made it mandatory for banks to link all new floating rate personal or retail loans and floating rate loans to MSMEs to an external benchmark like the Repo rate effective