How borrowers are exploited by banks
An internal study group of the Reserve Bank of India (RBI), chaired by Janak Raj, principal adviser, monetary policy department, has lambasted commercial banks for their non-transparency in fixing loan rates and graphically dissected how most Indian banks exploit borrowers.
The mandate for the study group, set up in July, was to look at the various aspects of the current marginal cost of funds based lending rate (MCLR) system and explore a new benchmark for banks’ loan rate that could improve monetary transmission.
Since we have a bank-led financial system, monetary transmission is a must to make the RBI’s policy rate effective; but achieving this continues to be a challenge for a string of reasons, including banks’ unwillingness to pass on the benefits of low interest rates to customers and their proclivity to neglect existing customers and woo new customers with lower-interest rate loans.
Lending rates were deregulated in 1994 and banks were directed to disclose their prime lending rates (PLRs)—the interest rate charged for the most creditworthy borrowers. RBI followed this up in 2003, introducing a benchmark-PLR, or BPLR, below which no bank should lend money. It failed. There was a structural problem. Even though loan rates were deregulated, a few lending rates were still mandated and linked to banks’ BPLR. For instance, loans to exporters were given at 2.5 percentage points below BPLR; loans to small farmers, too, were priced cheaper than BPLR. So, banks preferred to keep their BPLR at an artificially high level and charge most of their borrowers a rate much below the benchmark rate. That was the only way they could prevent loan rates for exporters and small farmers from declining to a level that did not even cover the cost of funds.
In 2010, the BPLR was replaced with base rate—the minimum rate for any loan—and the banks were to charge the borrowers a spread over this rate, depending on the borrower’s risk profile. The base rate was to be arrived at basis the cost of funds (average, marginal or blended cost).
Apart from the cost of funds, the other factors that were to be taken into account while calculating the base rate, included overheads such as the cost of running branches and employee wages, the so-called negative carry on the cash reserve ratio, or CRR (the portion of deposits banks keep with the regulator on which they do not earn any interest), and the level of bad loans (as they don’t earn interest from such loans). There was no cap on the spread between the base rate and the actual rate that a bank would charge its customers as long as they could justify the spread.
The biggest difference between the BPLR regime and the base rate regime was supposed to be transparency as the banks were to explain the rationale behind the actual loan rate, but it failed as banks were non-transparent.
So, the MCLR system came into being in 2016. Unlike the BPLR and the base rate, the formula for computing the MCLR was prescribed by RBI. Its basis has been the marginal cost, or the rate offered on new deposits, across different maturities. To this, banks add the negative carry on CRR, operating cost and a tenure premium for the risk associated. Basis all these, the banks announce the MCLR for at least five different tenures of loans—overnight, one-month, three-month, six-month and one-year, and the final rate is decided on the spread over MCLR. Bankers review their MCLR and publish them once a month on a particular date. The study group has found that while the overall transmission from the changes in the policy rate has been “slow” and “incomplete” under both the base rate and the MCLR systems, interest rate transmission on fresh loans was better than on outstanding loans. This means while the interest rate goes down, banks woo new customers with lower rates, but refuse to give the benefit to existing customers.
Also, they are relatively faster in transmitting the policy rate when the monetary policy is tightened, but slower during the easing phase. This means when the policy rate goes up, they are quick in raising their loan rates; but when the policy rate goes down, they are slow in cutting rates. For instance, the pass-through to outstanding loans from the policy rate was around 60% between July 2010 and March 2012 when the policy rate was hiked but less than 40% between April 2012 and June 2013 when the policy rate was cut.
Indeed, the monetary transmission has been impeded by the fact that banks mostly offer fixed rate for deposits and floating rates for loans, piling bad assets (on which they do not earn anything), and their inability to cut deposit rates because the competing government-run small saving rates as well as tax-adjusted returns from mutual funds are higher; but what is most disappointing is the way they manipulate the rates.
The study group’s analysis has found that banks manipulated the methodologies for calculating the base rate and the MCLR to either “inflate” the base rate or prevent the base rate from falling in line with the cost of funds. This has been done by “inappropriate” calculation of the cost of funds, not changing the base rate even after the cost of deposits declined “significantly” and inclusion of new components in the base rate formula to adjust the rate to a “desired level”. The slow transmission to the base rate loan portfolio was accentuated by the long (annual) reset periods. As a result of all these, there has been a sharp increase in the return on net worth for some of the banks, which is out of tune with their past track record.
In their quest for higher profits, the bad-loan laden Indian banks have been focusing more on the spread over the benchmark rate than the benchmark itself for deciding on the overall loan rates. While the spread over the MCLR varies from bank to bank due to “idiosyncratic factors”, the study group has found that the variations in the spreads across banks are too large and cannot be explained by the business strategy and credit risks. The most disturbing factor is the lack of transparency and “arbitrariness” in the way the banks change the spreads. While the spread over the MCLR was expected to play only a small role in determining the lending rates by banks, it turned out to be the key element in deciding the overall lending rates. This has made the entire process of setting lending interest rates by banks opaque and impeded the monetary transmission.
The key findings of the study are:
A large reduction in MCLR is partly offset by some banks by a simultaneous increase in the spread in the form of business strategy premium. (This means a bank can cut its MCLR by as much as 100 basis points (bps) and, at the same time, raise its spread by 75 bps to pass on only a 25-bps benefit to the borrowers.)
There is no documentation of the rationale for fixing business strategy premium for various sectors.
Many banks do not have a board-approved policy for working out the components of spread charged to a customer.
Some banks do not have any methodology for computing the spread, which is merely treated as a residual arrived at by deducting the MCLR from the actual prevailing lending rate.
Finally, the credit risk element is not applied based on the credit rating of the borrower concerned, but on the historically observed probability of default in a particular sector.
As big as the Libor scam?
All these tempt to make us believe that the loan rates of Indian banks are as big a scam as the Libor (London interbank offered rate). Published daily, Libor is a benchmark interest rate based on the rates at which banks lend unsecured funds to each other on the London interbank market. An international investigation had revealed a widespread manipulation of a string of banks led by Deutsche Bank AG, Barclays Plc, UBS, Rabobank and the Royal Bank of Scotland, and the banks were penalized at least $9 billion for making profits on loans worth over $300 trillion given worldwide. I wish the RBI study group had made an attempt to quantify the amount of loans that have been disbursed by the Indian banks through manipulated rates. As on 29 September, Indian banks have a loan portfolio of Rs80 trillion.
After evaluating 13 possible “candidates”, the study group has zeroed in on three instruments that can be considered for a new benchmark rate – the treasury bill yield, the certificate of deposit rate and the RBI policy rate (repo rate). Its bias is clearly tilted towards the repo rate. It has recommended that the new rate should come into effect from April 2018, exactly two years after the introduction of the MCLR, and the banks must transfer all existing loans linked to BPLR, base rate and MCLR in one year, by April 2019, without any conversion charge. It also says that to make the monetary transmission more effective, the loan rate should be reset every quarter and not annually.
Indeed, the base rate is the most robust rate among all, but is it fair to make it the benchmark rate when banks’ cost of funds has very little to do with it? Banks are allowed to borrow from RBI only up to 1% of their net demand and time liabilities, a loose proxy for deposits, and that, too, after offering collaterals with a margin—5% for central government papers and 10% for state government papers.
So, if RBI chooses the base rate as the benchmark rate, it needs to evaluate banks’ access to money at the repo rate and also the collaterals. Also, to have a bearing of the RBI’s policy rate on banks’ deposit rate, we need to pare the small savings rate. Despite RBI’s sincere efforts, not much headway has been made on this. Small savings rates have political overtones in India, which does not offer any safety net to its citizens, and a large segment of senior citizens lives on the interest income earned from such savings. Since they do not offer instant liquidity, the small saving schemes could offer relatively higher rates than bank deposits, but they need be in sync with the overall interest rate structure in the system. Besides, to make the benchmark rate for loans more effective, banks must convert a substantial portion of their liabilities into floating rate deposits.
Two benchmark rates?
Another important issue is that developed markets typically have two benchmark rates—one for retail loans and another for corporate loans. For instance, in the US, the prime rate—normally 3 percentage points higher than the Federal Reserve rate—is the benchmark rate for all consumer and retail loans, and Libor is the reference point for all corporate loans. Similarly, in the UK, the Bank of England’s base rate is the benchmark rate for consumer and retail loans, while Libor is the benchmark for commercial loans. Should we also look for two rates, or allow banks to have appropriate spreads for different sets of customers?
Where is the root of the real problem? With the benchmark rate, or the banks? Many commentators in the US were in favour of scrapping the discredited Libor; but despite the scandal, Libor continues its role as the primary benchmark for global lending rates. The UK Parliament passed a law in 2012 to strengthen financial regulations and reform the Libor system.
Since RBI has already created an enforcement wing for market investigations, it can be entrusted with the job of ensuring transparency in the implementation of MCLR instead of going in for yet another benchmark. At the same time, of course, RBI needs to address market imperfections such as higher small savings rate.
Some bankers are not happy with an “interventionist” RBI. They say that instead of micromanaging, the regulator should leave it to the market, and competition will iron out all distortions. I also do not support micromanagement, but that does not mean banks should compromise on transparency and manipulate rates. Even a free market does not ensure competition. The banking industry took seven years to exercise its freedom after the savings bank rate was freed. Till the rush of liquidity in the system that followed demonetization, the market could not break the cartelization of banks on determining savings bank rate.
The Janak Raj panel has done a good job. My only quibble is, there is no recommendation to punish manipulators despite impeccable evidence. Perhaps RBI can consider it—to force banks to take the regulator seriously.
Tamal Bandyopadhyay, consulting editor at Mint, is adviser to Bandhan Bank. He is also the author of A Bank for the Buck; Sahara: The Untold Story, and Bandhan: The Making of a Bank.
His Twitter handle is @tamalbandyo. Respond to this column at firstname.lastname@example.org.