Small saving instruments and monetary policy transmission

Small saving instruments and monetary policy transmission

Subject: Economy

Section: Monetary policy and banking

Context:

The Reserve Bank of India (RBI) has sought a further reduction in interest rates on small saving instruments (SSIs) for the first quarter of fiscal 2022-23.

Meanwhile, as per the RBI, with credit and deposit offtake picking up, some commercial banks have raised interest rates on term deposits and further,

• The extent of pass-through of policy rate reduction to the median term deposit rate (MTDR) increased.
• the one-year median marginal cost of funds-based lending rate (MCLR) of banks softened cumulatively.
• In response to the repo rate cut, the weighted average lending rates (WALRs) on fresh and outstanding rupee loans declined.

Concept:

SSIs include Public Provident Fund (PPF), Sukanya Samriddhi Account (SSA), Senior Citizen Savings Scheme (SCSS), National Savings Certificate (NSC) and Post Office deposits.

Interest rates on SSIs are administered by the government. These administered interest rates are linked to market yields on government securities (G-secs) with a lag and are fixed on a quarterly interval at a spread ranging from 0-100 basis points (bps) over and above G-sec yields of comparable maturities

Although interest rates on SSIs have been going down in line with the trend in the financial system, these instruments still offer higher rates than bank deposits making monetary policy transmission difficult.

EPF Organization’s Central Board of Trustees (which includes representatives of workers, management and the Govt) has approved the EPF rate cut.

• Following are the list of other savings instruments and its current rate which are also lower:

• EPFO’s call to keep at 8.1% has yet to come to the Finance Ministry for approval.

Transmission of Monetary Policy: The transmission of monetary policy describes how changes made by the Reserve Bank of India (RBI) to the policy rate flow through to economic activity (like lending) and inflation.

• Internal Benchmark Lending Rate (IBLR): The Internal Benchmark Lending Rates are a set of reference lending rates which are calculated after considering factors like the bank’s current financial overview, deposits and non-performing assets (NPAs) etc. BPLR, Base rate, MCLR are the examples of Internal Benchmark Lending Rate.
  • Benchmark Prime Lending Rate (BPLR)-BPLR was used as a benchmark rate by banks for lending till June 2010.Under it, bank loans were priced on the actual cost of funds. However, the BPLR was subverted, resulting in an opaque system. The bulk of wholesale credit (loans to corporate customers) was contracted at sub-BPL rates and it comprised nearly 70% of all bank credit. Under this system, banks were subsidising corporate loans by charging high interest rates from retail and small and medium enterprise customers.
  • Base Rate-Loans taken between June 2010 and April 2016 from banks were on base rate. During the period, base rate was the minimum interest rate at which commercial banks could lend to customers. Base rate is calculated on three parameters — the cost of funds, unallocated cost of resources and return on net worth. Hence, the rate depended on individual banks and they changed it whenever their cost of funds and other parameters changed.
  • Marginal Cost of Lending Rate (MCLR): It came into effect in April 2016. It is a benchmark lending rate for floating-rate loans. This is the minimum interest rate at which commercial banks can lend. This rate is based on four components—the marginal cost of funds, negative carry on account of cash reserve ratio, operating costs and tenor premium. MCLR is linked to the actual deposit rates. Hence, when deposit rates rise, it indicates the banks are likely to hike MCLR and lending rates are set to go up.

Issues Related to IBLR Linked Loans:

-The problem with the IBLR regime was that when RBI cut the repo and reverse repo rates, banks did not pass the full benefits to borrowers.

-In the IBLR Linked Loans, the interest rate has many variables including bank’s spread, their current financial overview, deposits and non performing assets (NPAs) etc.

-Due to this, such internal benchmarks did little to facilitate any swift change in interest rates as per changes in RBI repo rate policy.

-The opacity in interest rate setting processes under the internal benchmark regime hinders transmission to lending rates.

• External Benchmark Lending Rate–To ensure complete transparency and standardization, RBI mandated the banks to adopt a uniform external benchmark within a loan category, effective 1st October, 2019. Unlike MCLR which was internal system for each bank, RBI has offered banks the options to choose from 4 external benchmarking mechanisms:
  • The RBI repo rate
  • The 91-day T-bill yield
  • The 182-day T-bill yield
  • Anny other benchmark market interest rate as developed by the Financial Benchmarks India Pvt. Ltd.

What makes monetary policy transmission difficult?

As per theory, at lower interest rates, people are expected to borrow and spend more, the more the money circulates in the economy, the greater would be the economic activity. Much, however, depends on how effectively, with respect to speed and quantum, the transmission mechanism works.

However, there have been instances of incomplete pass-through and longer periods of transmission, and uneven transmission, particularly, lower during the easing phase and higher during the tightening phase. Some of the reasons behind the inflexibility of the interest rates which prevailed a decade ago still exist today.

All those measures that reduces liquidity of commercial banks or increases cost of getting liquidity in at a time when accomodative monetary policy is being undertaken to reduce cost and availability of funds with the commercial banks are the major cause of downward inflexibility in transmission

• Rigidity in savings deposit interest rate: Around 58% of the total deposits are term deposits and 77% of the term deposits are for 1 year and above. Most of the term deposits have fixed interest rates which mean the transmission is effective only for fresh deposits. Besides, banks have no incentive to decrease the deposit rate with the decrease in repo rate due to high operating expenses of savings accounts and already stressed balance sheets.
• Higher deposit rates which forces to keep the lending rate high in spite of reduction in policy rates as high dependency on bank deposits for lending.
• Large number of shadow banking institutions which take away deposit share of commercial banks.-With an increased risk appetite, financial literacy, good performance of stock markets and well-structured products, households are diverting a part of their savings to risky assets like mutual funds. Risk-free instruments including public provident fund, national savings certificate, etc. also compete with bank deposits. Despite quarterly review of interest rates, movement in small savings rates has remained highly inflexible.
• Higher business cost of banks and non-interest operating expenses
• Inflation- which reduces real savings
• Higher cost of acquiring and servicing customers
• Procedural bottlenecks in recovery of dues by banks coupled with large borrowings by the government.
• High NPAs-Increased cost of funds and liquidity crunch due to high NPAs impact bank’s profitability, further impacting transmission

Solution?

• Linking repo rate with deposit rate can address the issue and some banks are currently moving towards this system.
• High dependency on bank deposits for lending has resulted in interest-rate stickiness. Banks also need to look at other sources to fund lending such as issuance of debentures/commercial papers and borrowings from the capital market.
• Banks can move over to a variable interest rate structure on longer term deposits.
• To strengthen monetary transmission, the government needs to pro-actively peg the small savings rate with the G-sec bond yields.
• The asset resolution and bank recapitalisation are expected to strengthen bank balance sheets and improve banks’ willingness to change their lending rates in tandem with the change in the policy rates.
• Faster implementation of linking interest rates under external benchmarks at least once in three months from the earlier practice of resetting interest rates once in a year under MCLR will greatly help in transmission of the RBI’s monetary policy.