Posted by: Uma Shashikant and Deepa Vasudevan on Wed, Dec 17th, 2014
How do banks respond to RBI's Rate Actions? Part 1 : Banks respond faster to hikes, not cuts
As expectations for a lower interest rate regime are growing, the critical question to ask is whether banks would also reduce their lending rates. If the rate cuts from RBI, whenever they happen, are not transmitted through the banking channel to borrowers, revival of consumption and investment, and therefore economic growth may not be as fast as expected.
How have the lending rates or the base rates of the banking system behaved over time? The base rate is the minimum interest rate at which banks can lend. All rupee denominated domestic loans have to be made at or above the base rate. A bank can have only one base rate. Banks are free to set their base rates on the basis of any benchmark, or by using any appropriate methodology, provided the method of fixing the base rate is consistently applied. The base rate is expected to include cost of funds, the opportunity cost of funds locked into SLR and CRR, some overhead costs, and some measure of profit. RBI norms required the base rate to be reviewed at least once in a quarter. Changes in the base rate have to be disclosed to the public in a transparent manner.
The base rate system came into force on July 1, 2010. Before that, loans were priced with reference to a bank-specific benchmark Prime lending rate (BPLR). The key difference between the two systems is that banks were allowed to lend at rates below the BPLR. As a result lending rates were not transparent, and RBI was unable to assess if changes in policy rates were being effectively transmitted to bank lending rates. The adoption of a base rate system was expected to enhance transparency in loan pricing as well improve the monetary transmission mechanism.
In July 2010, when the system became operational, leading banks set their base rates at around 7.5%. Between March 2010 and April 2012, RBI increased the repo rate by a whopping 3.5%. Base rates also moved up to 10% in response to the rate tightening. The subsequent easing cycle- until July 2013- saw a 75 basis points decline each in repo rate and CRR, while the base rate fell into the range of 9.6% to 10%. Since the start of fiscal 2014-15, the base rate has remained at 10% (Pic 1).
Pic 1 Base Rates and Repo Rate
Source: RBI, Reuters, CIEL Research
It can be seen that the transmission from policy rates to the bank base rate is not symmetric. When rates went up in 2010 liquidity was tight, and an increase in policy rates was immediately transmitted to an increase in base rate. But when the RBI dropped rates in 2012 banks not only delayed the lowering of base rates, but also did not persist with it in 2013. This asymmetric monetary transmission dilutes the impact of monetary policy. RBI’s monetary policy actions are effective when it is tightening, but not as effective when it is easing. This one-way effectiveness has been observed by several studies, most recently in the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework, chaired by Shri Urjit Patel.
When RBI began to reduce rates in 2012, the banking system was caught in a situation of declining deposits and tight liquidity, which created a “wedge” between deposits and credit. During the 2010-2013 period, credit was growing faster than deposits. Insufficient deposit mobilisation prevented banks from cutting deposit rates. This, in turn, limited their ability to reduce the base rate. This structural deficiency was primarily responsible for the poor transmission of RBI’s rates cuts by the banking system. How the situation is different now in 2014, is what we will see in Part 2 of this blog.
 RBI permits the following loans to be priced without reference to the base rate: (a) DRI advances, (b) loans to banks’ own employees including retired employees, (c) loans to banks’ depositors against their own deposits.
 Base rate was made applicable for all new loans and old loans that came up for renewal. Customers with existing loans were to be given the option of switching to the base rate system without any charges.