Monetary policy changes - impact

OFF-CYCLE REPO RATE AND REGULATORY CHANGES

RBI Governor surprised everyone by convening the Monetary Policy Committee (MPC) meeting in advance (originally scheduled for June 3 to 5, 2020) to assess the economic risks arising due to the impact of ongoing COVID-19 pandemic. (i) Affordable lending rates to revive growth, (ii) keep the funds supply chain from the banks hassle free through various liquidity measures and (iii) ease the financial stress through supportive measures had been the hall mark of the RBI approach, ever since the present Governor assumed charge. The announcements were no different this time as well.

Salient features:

ü Policy Rate reduced by 40 bps and 
    Effective rates are: Repo: 4.00%; Reverse Repo: 3.35%; Bank Rate/MSF: 4.25%

ü Moratorium on term loan instalments and working capital interest extended upto 31.08.2020 (in effect six month moratorium from 01.03.2020 to 31.08.2020) and

ü   Additional liquidity easing measures by way of rollover of Refinance facility of SIDBI and line of credit to EXIM Bank.(15000 cr. each)

I. Effect of Policy Rate reduction on lending rates: While the transmission of policy rate changes was quick and smooth in respect of money market instruments like T-Bills, CPs and CPs, the same did not happen in the banks’ lending rates. Prior to the above reduction of 40 bps, repo rate was reduced by 210 bps.(from 6.5 to 4.40) in a period of more than one year.  However during the same period, one year average MCLR (marginal cost of funds-based lending rate) came down by 90 bps. and the average lending rate on fresh rupee loans came down by 114 bps , representing just half of repo rate reduction.

If we look at the history, RBI was not happy with the transmission when the banks were linking their (floating) interest rates with their internal bench mark rates (IBR) (BPLR, Base Rate and MCLR, etc.). Hence, external bench mark linked loan rates were made mandatory since 1st October 2019. Now it is applicable for all fresh retail loans/ MSMEs. RBI also made it compulsory that all loans linked to external bench mark rates (EBR) shall be reset at least once in three months, so that the existing borrowers also get the benefit of rate reduction within a minimum time lag. But there is a long way to go, as EBR loans represent just 5.4 per cent of the total floating rate loans, which constitutes roughly 76% of the total loans in the banking system.

IBR linked floating rate loans, constituting nearly 95% of floating rate loans, are governed by interest rate structures linked to different internal bench marks over a period of ten years. More than 82% are linked to MCLR and in majority of the cases, interest rates are due for reset only after one year. The other internal bench mark base rate (replaced by MCLR in 2016) still constitutes 12 per cent of floating rate linked loans. (I have not discussed the BPLR linked loans as they comprise only 0.7% of the floating loans). While the base rate is calculated using average cost of funds, MCLR is based on incremental cost of funds, explaining the reason for the difference in the interest rate between the two IBRs and also why repo rate change has no effect on them.

Fixed interest rate loans, aggregating 24 per cent of the total loans, carry contracted rates and policy rate changes have no impact even on fresh loans under this category. Nearly 15 per cent of the total loans of public sector banks' are fixed interest rate loans and majority of them relate to agricultural crop loans (KCC loans).  So the policy rate changes will have no impact on KCC loans, though they form part of priority sector.

What should be done to ensure interest transmission into lending rates: If the well-intended policy rate changes are to be passed on to majority of the bank borrowers, the need of the hour is to have only two floating rates, one linked to the external bench mark and the other linked to internal bench mark. And there should be a trigger to review the fixed rate loans also (other than loan against time deposits, which carry fixed rates) whenever the policy rate change is beyond 100 bps. in a year. Towards this end, my suggestions are:

1.  Base Rate/BPLR linked loans shall move over to either MCLR or EBR. Even now, provision is available for customers to switchover to other floating rate loans at mutually convenient terms, by payment of a flat fee to the banks. However, majority of them are not aware, since this option is never publicised in a big way. RBI, as a one-time measure, can conduct an awareness campaign through its website, electronic media and newspapers. It can also advise the bankers to display rate conversion availability in their banking halls and ATM outlets. This can also be one of knowledge information messages in their websites. This will not only bring interest rate parity among new and existing borrowers in the same loan category and risk profile but will also help in consolidating the various internal bench marks into one.

2.     Agricultural Cash Credit (ACC) loan rate at 9 per cent was fixed at least ten years back.  Repo rates underwent several changes and since Feb 2019, the rate has come down by 250 bps.  But even now, ACC carries the same interest under the pretext that the rate is fixed and the loan is eligible for interest subvention of 2 per cent, if the renewal takes place before due date. When the borrowers in the other sectors can enjoy the benefit of policy rate reduction, why ACC/KCC should be left out?  RBI should consider introduction of triggers, beyond which the fixed interest loan rate shall be reviewed.  For example, RBI can stipulate that whenever there is a rate reduction/increase of more than 100 bps. in a year, the fixed interest rate loans given to priority sector category like agri./ exporters shall be reviewed for effecting necessary adjustments.

3.  While implementing EBR linked loan rates, banks were given the freedom to decide the spread over the external benchmark chosen, with a condition that the components of the spread, except credit risk premium, can be changed once in three years only. However, unlike the IBR, where the cost of funds is the core, to which the other costs are added to arrive at the link rate, no such formula is designed in respect of EBR. This makes EBR linked loan rates, especially the spread over EBR chosen, loose ended and they differ by a wide margin among banks. Though spreads could not be changed before three years, some banks have already found a way out by charging higher rates on new loans (since the restriction on spread applies only to existing borrowers!). So there is an urgent need to have a well-defined methodology in arriving at EBR linked loan rates.

4.   Maximum cap on micro finance interest rates quoted by MFIs are still linked to the average base rate of the top five banks. MCLR replaced base rate three years back.  Hence this instruction needs to be reviewed. Again the MFIs are permitted to quote the lower of cost of funds+10%/12% or average base rates of top five banks multiplied by 2.75.  This is quite high, when compared to the present repo rate. This should also be reviewed.

 II. Moratorium upto six months: RBI has permitted conversion of accumulated interest on working capital facilities into a funded interest term loan (FITL) and defer the instalments on term loans falling between March 1 to August 31, 2020 by six months.  

     ü RBI has assumed that all term loans are repaid using EMI method. While this may be true for term loans availed by individuals, the method followed for others is to collect interest at monthly/ quarterly intervals and the instalments of principal amount at monthly/quarterly/half yearly rests.  So it is necessary to extend FITL for the interest portion in such term loans along with deferment of instalments due in the relevant period by six months.

 ü Deferring the interest portion/monthly instalments by six months across all loans is an acknowledgement of severe liquidity crunch in the entire economy. Though not said in so many words, the offer is short term rehabilitation. As it will be a big burden on the customers to pay higher interest on accumulated interest as well, FITL should carry a fixed rate of interest not exceeding the respective bank’s 3 month MCLR.

 ü When the business activity/operations resume, there will be a time lag of at least three/six months to achieve pre COVID sales/revenues. So the repayment period for FITL, representing overdue interest accrued during 01.03.2020 to 31.08.2020, should be extended upto 31.03.2022. 
     

     ü There will be business units where the orders might have been cancelled, or the said orders could not be executed or the stock-in-process could become obsolete due to stoppage of production. There could be other situations also, which in effect renders the roll over of the entire working capital impossible. So on a case to case basis, restructuring the account and grant of Working Capital Term Loan also may become necessary.  The regulator should permit such restructurings as 'standard' provided the exercise is completed before 31st August 2012, the last date permitted for moratorium of term loan instalments and deferment of working capital interest.  

  

 III. Targeted LTRO RBI introduced Targeted Long Term Repo Operations (TLRTO) and Special Liquidity Window for Mutual Funds in April 2020. Under the above schemes, banks are eligible to avail money at repo rate with a condition that the money obtained shall be invested in CPs, NCDs or bonds of NBFCs/HFCs/purchase of securities from MFs. This is done to improve the liquidity position of NBFCs/MFs/HFCs. In the same way, a new targeted LTRO can be introduced for financing the large industries/PSEs for clearing their overdue payable to MSMEs. Large number of MSMEs who supply products/services to large industries/PSEs are yet to receive their payments. This will ease the liquidity position of MSMEs to a great extent.

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References:

1.      Monetary Policy Transmission in India – Recent Trends and Impediments*
      RBI Bulletin March 2020

2.      RBI Governor’s Statement dated May 22, 2020