Back in the December monetary policy announced by the RBI, there was special mention of the banks shifting to an external benchmark for pricing loans. This was part of the policy statement and was expected to make a big difference in the way banks price their loans. The new external benchmarking for loans was to become effective from April 01st but just a few days ahead the government has put off the plan. What exactly was this plan and why is it not taking off for now?
About loan benchmarking
This announcement was made when Dr. Urjit Patel was still the Governor of the RBI. The idea was that when the RBI cut repo rates, the transmission was not taking place as anticipated. This was reducing the efficacy of monetary measures as the cost of borrowings was not coming down. Hence RBI had then announced the intent to move towards external benchmarking of loans to retail borrowers and small businesses, which were of a floating rate variety. The idea was that by linking the price of loans to an external benchmark like the repo rate or the Libor, the transmission of rate cuts will be more seamless. This will also make the monetary policy more effective. However, in the last few months, the government and the RBI had received objections from various banks as a result of which, the decision has been taken to study the matter in greater detail before a decision.
All about the cost of funds
Currently, Indian banks benchmark their lending rates based on their cost of funds. Some banks look for average cost of funds for most borrowers and incremental cost of funds for select borrowers. Either ways, the rate at which loans are given is benchmarked to the cost of funds. The RBI has suggested that the current practice has the potential to inculcate inefficiencies in the banking system as the bank has no incentive to bring down its cost of funds. Of course, the pressures of competition are quite critical but the market for loans is so wide and disparate that it does not really work like a competitive market. Banks have been unwilling to shift their pricing away from cost of funds. Their contention has been that any pricing divorced from the cost of funding is a recipe for disaster.
What about the cost of deposits?
Actually, that is the million dollar question. To have a fully flexible benchmark for lending, you also require a flexible benchmark for pricing the deposits. However, a floating rate deposit is something neither the depositor nor the regulator is willing to accept. In the absence of benchmarking of deposits, the entire concept of loan benchmarking is likely to be one-sided and therefore ineffective. This has been tried in the past also. Eventually, banks gravitate towards the cost of funds!
