Reform floating rates

Pegging interest rates to external benchmarks is the way forward

Acommittee that had been tasked by the Reserve Bank of India (RBI) to look into banks’ loan charges has suggested that floating interest rates for home and personal loans be linked to an external indicator such as the RBI’s repo rate, the treasury bill rate or the interest rate on certificates of loan deposits. This would be an important step towards transparency, especially for borrowers, and the RBI should implement it as soon as possible. The committee, headed by Janak Raj, has also suggested that bank charges for converting loans to different interest rates following a change in the policy rate be forbidden. The RBI has pointed out that “arbitrariness in calculating the base rate” by banks as well as the various spreads charged over them from different customers have “undermined the integrity of the interest rate setting process” and that such processes are “not in sync with global practices on pricing of bank loans”.

As matters stand today, there is too much heterogeneity in how customers are treated by banks. A bank can set its “prime rate” arbitrarily and then charge different borrowers various spreads over that prime rate. This means that when the RBI changes the overall policy rate, banks are under no obligation to pass on the change to their borrowers. They might, instead, keep the prime rate constant. Further, some customers – such as larger companies – might find it easier to renegotiate the floating interest rate on their loans when the overall rate changes. Indeed, floating rates are sometimes different for existing and new customers, which defeats the entire purpose of a floating interest rate. It is past time for this opaque and outdated system to be changed, and for Indian banks to be encouraged to install a more transparent and less discriminatory system. It would come as a big relief not just to home-owners but also to small and medium enterprises that are suffering from various other stresses at the moment.

The RBI has been struggling for some time with the relative ineffectiveness of monetary policy in the sense that its changes to the policy rate do not percolate down to the broader economy. A major problem has been banks’ own unwillingness to cut lending rates in response. A system in which floating rates have to respond to a rate cut should thus be speedily introduced. RBI Deputy Governor Viral Acharya has pointed out that internal benchmarks such as the base rate or the MCLR seem to offer banks a very high degree of discretion. Many factors provide them the flexibility to keep lending rates high even if the monetary policy rates are going down and are on an accommodative path. Mr Acharya has also called for a time-bound implementation of a new system in which floating rates are updated in response to the policy rate on a quarterly rather than an annual basis. This series of reforms should not be delayed, even if banks insist it will reduce their revenues. What is important is that transparency is increased in the small loans segment and banks begin to serve as more effective agents for the transmission of monetary policy.