The efficacy of central banking lies in how fast a central bank can get lenders to pass on changes in policy rates to the economy, by altering their loan rates.

In India’s case, it has been a Herculean task to make banks give borrowers the benefit of monetary policy changes and most of the Reserve Bank of India’s (RBI’s) efforts have been lost in transmission.

Enter the market benchmark as the new ingredient on which lenders will price their loan rates for micro, small and medium enterprises, and retail borrowers starting April next year.

While this sounds like a good idea, a fundamental problem remains.

This divorces lending rates from deposit rates by pegging them against a fast-moving interest rate decided by a democratic market.

Past formulae for lending rates also failed the test of transmission, simply because banks used the cost of deposits as the basis for setting rates. The charts alongside show how different loan pricing methods, including MCLR (marginal cost of funds based lending rate), failed the test.

But can deposit rates be thrown completely away from the equation?

Even if the central bank wants to remove deposits from the formulae, banks simply cannot.

Lenders are allowed to charge a spread over the market benchmark to compensate for the credit risk of the borrower and a premium for the tenure. Of course, due explanation has to be given as to why a specific spread was charged.

But the spread lenders charge is likely to reflect on their cost of deposits, and not just credit risk and tenure premium. No bank can be pulled up for protecting its margins as it is just good business sense.

That said, the spreads cannot be changed unless the credit profile of the borrower changes and hence cannot be arbitrarily charged. Fixed spreads will ensure loan rates move in tandem with the market benchmarks. Indeed, the 91-day T-bill rate, one of the suggested benchmarks, reflects policy changes and liquidity gyrations far better than any interest rate. To that extent, transmission will improve.

But the war of transmission can be triumphed only if banks are also allowed to price their deposits on a floating basis. Pegging the price of banks’ assets to a market benchmark without doing the same with their liabilities is unfair. Analysts believe that floating rate for deposits won’t take off and the only way lenders can limit the hit on margins is to hedge interest rate risks in the derivatives market.

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