MCLR: Monetary Transmission And The Impact On Banks
Posted in Finance Articles, Total Reads: 855
, Published on 19 February 2016
Banks in India have to price their loans based on the new formula unveiled by the RBI on 17th December 2015. RBI reason for change was to make monetary transmission easier and more effective. Monetary transmission is how well do policy changes by the central bank affect households and businesses. Monetary transmission plays a key role in controlling business cycles in the economy.
Ray Dalio in his paper ‘How the economic machine works’ talks about how business cycles are actually caused by credit cycles and banks play a crucial role in credit creation. The interest rates banks charge ends up determining how much households and businesses are going to borrow. The impact of getting the policy rate wrong can be very serious. Alan Greenspan the former Fed chairman is often blamed to have caused the 2008 financial crises in the US by keeping the policy rate too low for too long. He lowered the rates in 2001 in response to the dot com bubble but then took too long to start tightening which ended up fueling a boom in the housing market. So the failure of monetary transmission would mean the failure to control such a bubble if it were to happen.
Fig 1: Fed Funds Rate
In advanced economies developed debt and equity markets, interest rate channel which has an impact on cost of capital is used as a transmission mechanism whereas in case of emerging markets like India interest rate channel is found to be weak for transmission. In India the transmission is from policy rates to money market rates and retail lending rates. In India banks play a major role compared to debt markets. Even though non-bank borrowing has increased in the last decade, banks still play a major part in corporate borrowing. The graph shows percentage of corporate borrowing from banks and non-banks. This makes lending rates charged by banks very important for monetary transmission.
Fig 2: Corporate Borrowing
So if RBI cuts rates it wants the banks to transmit the rate cuts to its customers. Consider the last declining interest rates scenario in the years 2012 and 2013 when RBI made a 125 basis points cut in the repo rate, along with a 200 basis point cut in the CRR which led banks to reduce their base rate by just 50 basis points. Consider the recent scenario where RBI since January 2015 has cut policy rates by 125 basis points where as the banks have reduced their lending rates by only 60 basis points. Bankers have defended their position saying that deposits being of longer duration have locked in interest rates and recently there has also been lack of demand for new credit leading and hence the failure to transmit rate cuts. The diagram below best summarizes the transmission of monetary policy in India.
Figure 3: Monetary Transmission
Marginal cost of funds based lending rate (MCLR)
Historically RBI has made number of changes with the measurement of lending rates. In 2003 they introduced a Benchmark Prime Lending Rate (BPLR), the rate banks charge their most credit worthy customer. This was not effective in creating the transparency RBI expected. The calculation of BPLR was based on banks actual cost of funds and banks charged is corporate customer’s rates below BPLR. So in 2010 RBI introduced Base rate, which was calculated based on average cost of funds for the bank. Banks were given the freedom to choose the method to calculate their base rates. The banks were supposed to declare their respective base rates and they were not allowed to charge below this rate. Though better than BPLR the problem with base rate method was that it took longer to respond to policy changes. On the other hand calculations based on marginal cost of funds is expected to respond faster to rate cuts by RBI, since interest on new loans would quickly change. If RBI changes policy rate it would change the cost of acquiring new funds by the banks thus change their marginal cost of funds and if the loans are calculated using marginal cost the new loans given will be affected quickly by RBI’s move.
Basics of Banking
How do banks function? Very basically they take in deposits from customers and loan out funds provided by these customer to business and individuals.
The interest they charge on loans is higher than interest they pay out on deposits, keeping the margin in between these two interest rates as profit. This margin is called net interest margin (NIM).
Net Interest Margin= (Investment Returns – Interest Expenses) / Average Earning Assets
Below it shows typical balance sheet of a bank which funds its loans from deposits it takes from customers. The bank in this example charges an interest rate of 9.85% on the car loan and funds that loan from a deposit on which it pays 7%.
Bank: Car Loan = 9.85%
Bank: Deposit = 7.0%
Now banks can do this because their average duration of loans given is higher than the average duration of their deposits. In other words banks of taking advantage of an upward sloping yield curve. Yield curve is a curve that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. So the banks for borrowing for shorter period and lending for a longer duration. The risk that a bank faces is that when the short term deposits mature the rates at which they are renewed is unknown to the bank. Thus if the new rates are higher than before banks NIM will reduce. This risk that banks face is called interest rate risk (IRR). So when banks give loans for longer duration like mortgage loans they prefer floating rate loans since it’s almost impossible to predict interest rate movements extending 10 years into the future.
One simple way to reduce interest rate risk in maturity matching, though not always possible banks try to match the maturity of their deposits and loans. If the bank can match the maturity of a deposit to the maturity of a loan given or reset time of the interest rate of the loan the bank can effectively just lock in its profit with no interest rate risk exposure. Since on average banks have loans of longer duration, banks try encourage customer to have deposits for longer durations by offering higher interest rates on longer term deposits.
Effects of Introducing a MSLR on Net Interest Margin
When RBI plans to introduce a new formula for pricing loans it has to take into account what impact it would have on banks’ balance sheet in the short term. Sudden change to a new method of pricing loans would affect the NIM of the banks. The deposits banks have already taken would be of longer duration and interest rates on them fixed till maturity. So if the rates banks can charge on the loans drops suddenly we would see the banks NIM reduce and increase its interest rate risk. RBI has taken care of this problem by making the new rates applicable only to new loans after 1st April 2016. Also RBI has allowed banks to charge interest rate based on tenor of the loan. This is different from the previous practice were banks would calculate base rate based on 3 to 6 month deposit rates. Now tenor based calculations would reduce interest rate risk as banks will be able to charge higher rates to loans of longer durations. This would help banks also pay higher rates on deposits for longer durations thus leading to maturity matching.
The problem would arise in case of floating rate loans and hybrid loans (where the interest rates are partly fixed and partly floating) according to guidelines of RBI these loans have to adjust to MSLR. This would create pressures on NIM of the banks, as the deposits funding these loans would have fixed rates and would take longer to reprice.
Below the table shows how the new formula will impact banks. What we see is drop in rate across the table, an approx 30 basis points drop. This will bring down the current base rates of all banks. This would benefits those taking new loans, also those loans that are about to mature can be reset at lower rates.
Figure 4: Impact on NIM due to MCLR
What the future holds
In the short RBI had to look at how it would impact the banks if it had to change to a new way to calculate base rate. RBI has tried to make sure banks don’t end up taking a one-time hit on their interest margin. But the bigger question is would this move translate into a better monetary transmission, considering history of RBI that’s a difficult thing to predict. Let’s hope this new formula does the magic for RBI.
This article has been authored by Ashutosh Desai from SIMSR