Could Indian banks set their own lending rates, please?

The government will then have information on the efficient and inefficient enterprises that it owns and can make decisions on whom to nurture and whom to wither

The Reserve Bank of India (RBI) will be meeting for the first time after the elections this week. Whether or not the central bank reduces the policy rate by 25 basis points or 50 basis points is less consequential than the transmission of policy rate cuts to market interest rates. Well, that is, if India has market-determined interest rates in the first place.

In December 2018, RBI decided that it would ask banks to set interest rates for loans based on some benchmarks like the commercial paper rate, the T-bill rate or the repo rate. Detailed guidelines were supposed to be issued later in the month and the new regime for bank lending rates was supposed to come into effect from April 2019. The guidelines were not issued in December and the shift to “external benchmarks" for lending rates has been postponed. For now, India will stick with the “marginal cost of funds-based lending rate" (MCLR) regime. That regime was put in place in 2016 when Raghuram Rajan was the governor of RBI.

In September 2017, an internal committee appointed by the central bank to study the efficacy of the MCLR and the previous base rate regime submitted its report. Those who do not know what MCLR is should refer to Table II.1 in page 7 of the report. The important point here is that the MCLR based lending operates in a manner such that the MCLR is effectively the minimum lending rate as a bank cannot go below the MCLR even if it wants to. Many elements of the so-called marginal rate do not change in the short run. So, it is not quite marginal costing.

It is difficult to understand the philosophy behind such an elaborately prescriptive regime for interest rates. Interest rates are the price set by profit-seeking commercial banks. They are operating decisions to be taken by the managements of the institutions. Ideally, even owners should stay away from interfering with such decisions. Owners can demand profits but not set prices. Prices are set in competitive markets. Indeed, even in the government-dominated banking sector as in India, it is possible to let banks set their interest rates. The government will then have information on the efficient and inefficient enterprises that it owns and can make decisions on whom to nurture and whom to wither. Lest readers have forgotten, the success of East Asian economies with their industrial policies is not that they chose and helped winners but importantly, they let the non-performers perish.

More bizarre than the owner interfering in operating decisions is the role that the regulator is playing with its elaborate prescriptions on interest rates that lenders charge. MCLR is really administered pricing for the banking industry, similar to how refineries were compensated for processing crude oil. It was a cost-plus formula. There is no incentive for competition nor for efficiency. The report notes that earlier banks used to lend below the prime lending rate and that the reason for abandoning that system was that it was not possible for RBI to ascertain if its policy actions were transmitted to the market. That sounds unpersuasive.

With its economic reforms in 1991, India was supposed to have liberalized the financial sector first. However, it appears that the central bank has backtracked. Banks should have the freedom to set their lending rates. Sometimes, they may price it in such a way without recovering all their fixed costs from all of their assets. Lower interest rates can be used to attract better-quality borrowers. Keeping all interest rates high pushes good-quality borrowers to the capital market or even to overseas markets. Public sector banks are left with relatively lower-quality borrowers. It is partially evident in the current bad debt overhang that government-owned banks are still grappling with. Higher interest rates on paper are poor consolation.

Hasmukh Adhia, former finance secretary and now the non-executive chairman of the Bank of Baroda, in a recent op-ed for Business Standard hinted at the need to bring down interest rates on small savings schemes for banks’ MCLR to come down. Higher rates on small savings schemes are one of the reasons why banks are unable to lower interest rates on deposits when the central bank cuts interest rates.

For the new government, restoring India’s banking system to health is a priority. The package of measures should include some privatization, some consolidation, corporatization of public sector banks so that they are on a level playing field with private sector banks, setting performance criteria for recapitalisation, granting freedom for banks to price their products and a formula for setting interest rates on provident funds and small savings that allows banks to compete more effectively for deposits.

Finally, just as it is important for the government to use the present crisis in Indian banking to reimagine its architecture for the future, the regulator should reflect on whether its regulatory architecture is protecting or even encouraging inefficiency, cartelization of Indian banking and impeding technological progress. That is a topic for another column.

*These are the author’s personal views.V. Anantha Nageswaran is the dean of IFMR Graduate School of Business (KREA University)