Transmission of policy rates through both lending and deposit rates improved since the Reserve Bank introduced external benchmark linked lending rate, according to study by RBI economists.
The cumulative reduction of policy repo rate by 250 basis points (bps- one bps is 0.01 per cent) between February 2019 to June 2021 has resulted in 155 bps decline in marginal cost of funds-based lending rate (MCLR) during the period.
But the transmission improved significantly after the introduction of external benchmark regime., notes the study published in RBI’s latest monthly bulletin. It also adds that a combination of surplus liquidity conditions amidst weak credit demand has enabled banks to lower their deposit rates and hence the lending rates.
The weighted average domestic term deposit rate (WADTDR) on outstanding rupee deposits has declined by 152 bps since October 2019 as compared to the decline of mere 7 bps during February-September 2019. The weighted average lending rate (WALR) on outstanding rupee loans has declined by 113 bps since October 2019 as compared to a rise of 2 bps during February-September 2019.
“Since the rate cut cycle started in February 2019, more and more loans linked to MCLR, primarily in the 1-year bucket are getting reset since February 2020 contributing to the improvement in transmission to WALR on outstanding loans” notes the report. “The adoption of external benchmark-based pricing of loans strengthened market impulses for quicker adjustments in deposit rates”. The share of outstanding loans linked to external benchmarks has increased from as low as 2.4 per cent during September 2019 to 28.5 per cent during March 2021.
The external benchmark system has incentivised banks to adjust their term as well as saving deposit rates as lending rates undergo frequent adjustments in line with the benchmark rates, to protect their net interest margins thus broadening the scope of transmission across sectors that are not even linked to external benchmarks.
The study also notes that a combination of surplus liquidity conditions amidst weak credit demand has enabled banks to lower their deposit rates and hence the lending rates.
But the pace of transmission has varied across bank groups with foreign banks passing the most of the rate cuts to their clients compared to public sector banks. This is largely because of the composition of the liability structure. Since public sector banks focus more on retail deposits their pricing power is restricted because of competition from alternative instruments like small savings schemes.