RBI: Policy transmission improves post external benchmarks

Transmission of price policy through both loan and deposit interest rates improved since Reserve Bank introduced external benchmark lending rates, according to research by RBI economists.

The cumulative reduction in the policy repo rate by 250 basis points (bps- one bps is 0.01%) from February 2019 to June 2021 has resulted in a decrease in the marginal cost of the capital-based lending rate. 155 bps (MCLR) period.

But transmission improved significantly after the introduction of the external benchmark mode., notes the study published in RBI’s latest monthly newsletter. It also added that the combination of excess liquidity conditions amid weak credit demand has allowed banks to reduce deposit rates and therefore lending rates.

Weighted average domestic term deposit interest rate (WADTDR) for outstanding rupee deposits has fallen 152 bps since October 2019 compared to a decline of just 7 bps between February and September 2019. The weighted average lending rate (WALR) on rupee loans has fallen 113 bps since October 2019 compared to a 2 bps increase during February to September 2019.

“Since the rate-cutting cycle began in February 2019, more and more MCLR-related loans, mostly within the 1-year limit, are being reset as of February 2020, contributing to improved transmission to WALR on outstanding loans”. “The adoption of external benchmark-based loan pricing has strengthened the market impulse to adjust deposit rates more quickly.” The outstanding ratio in relation to external benchmarks has increased from a low of 2.4% in September 2019 to 28.5% in March 2021.

The external benchmark system has encouraged banks to adjust terms as well as save deposit rates because lending rates are regularly adjusted in line with benchmark rates, to protect their net interest margins, because that extends the transmission range between domains even without involving external benchmarks.

The study also notes that the combination of excess liquidity conditions amid weak credit demand has allowed banks to reduce deposit rates and therefore lending rates.

But the rate of transmission has varied across banking groups with foreign banks passing most of the rate cuts to their clients compared to public sector banks. This is largely due to the composition of the liabilities structure. As public sector banks focus more on retail deposits, their pricing power is constrained by competition from alternative instruments such as small savings schemes.



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