The Reserve Bank of India (RBI) has brought into light challenges in the transmission of monetary policy due to the persistence of legacy lending rates. As of December 2024, portion of loans remains linked to the marginal cost of funds-based lending rate (MCLR). This situation affects how quickly changes in policy rates influence lending rates.
Monetary Policy Framework
Monetary policy in India aims to manage inflation and ensure economic stability. The RBI adjusts policy rates to influence borrowing costs. Lowering rates should ideally reduce the cost of loans, stimulating economic activity. However, the effectiveness of this transmission is hindered by legacy rates.
Legacy Lending Rates
Legacy rates include MCLR and other internal benchmarks. As of December 2024, 39.4% of floating rate loans were linked to these rates. Public sector banks (PSBs) have a higher share of MCLR-linked loans compared to private banks. This disparity affects how quickly banks can respond to policy rate changes.
External Benchmark-Based Lending Rate (EBLR)
In contrast to MCLR, the EBLR system was introduced in 2019 to enhance transmission speed. Loans linked to EBLR increased from 56.6% to 60.6% by December 2024. EBLR is primarily linked to the repo rate, allowing for quicker adjustments in lending rates.
Impact of Policy Rate Changes
Recently, the RBI reduced the policy repo rate by 25 basis points. Banks adjusted their repo-linked lending rates downward correspondingly. However, MCLR adjustments lag behind due to its longer reset period. Consequently, the weighted average lending rate (WALR) on outstanding loans decreased slightly, while fresh loans saw an increase.
Market Dynamics and Competition
Competition among banks influences lending rates. During the first half of 2024-25, the transmission of lending rates peaked. However, banks later reduced spreads to maintain market share. This competition can lead to a slower response to rate changes.
Deposit Rate Trends
Deposit rates have risen due to tighter liquidity and increased credit demand. From May 2022 to January 2025, the median MCLR increased . Consequently, the WALRs on loans and deposit rates also rose, reflecting changing economic conditions.
Conclusion of Current Trends
The current monetary policy landscape in India is shaped by the transition from legacy rates to more responsive systems like EBLR. While progress has been made, the persistence of MCLR-linked loans continues to pose challenges for effective policy transmission.
Questions for UPSC:
- Discuss the impact of legacy lending rates on monetary policy transmission in India.
- Critically examine the role of the External Benchmark-Based Lending Rate in enhancing lending rate responsiveness.
- Explain the relationship between deposit rates and monetary policy adjustments in India.
- Comment on the competitive dynamics among banks and their effect on lending rate adjustments.
Answer Hints:
1. Discuss the impact of legacy lending rates on monetary policy transmission in India.
- Legacy lending rates, such as MCLR, account for 39.4% of floating rate loans, slowing down responsiveness to policy changes.
- Public sector banks have a higher proportion of MCLR-linked loans than private banks, affecting overall transmission speed.
- Longer reset periods for legacy rates result in delayed adjustments compared to external benchmarks.
- Recent repo rate cuts have led to only slight decreases in weighted average lending rates due to these legacy rates.
- Overall, the persistence of legacy rates hampers effective monetary policy implementation, limiting economic stimulation.
2. Critically examine the role of the External Benchmark-Based Lending Rate in enhancing lending rate responsiveness.
- Introduced in 2019, EBLR aims to improve the speed of monetary policy transmission compared to MCLR.
- As of December 2024, EBLR-linked loans increased to 60.6%, indicating a shift towards more responsive lending rates.
- EBLR is primarily linked to the repo rate, allowing for quicker adjustments in response to policy changes.
- The EBLR system has facilitated faster adjustments in lending rates, as evidenced by recent trends.
- Overall, EBLR enhances the effectiveness of monetary policy by reducing the lag in lending rate adjustments.
3. Explain the relationship between deposit rates and monetary policy adjustments in India.
- Deposit rates are influenced by monetary policy changes, with recent hikes reflecting tighter liquidity conditions.
- From May 2022 to January 2025, the median MCLR increased, leading to higher deposit rates as banks adjust to maintain margins.
- Increased credit demand has also contributed to rising deposit rates, affecting overall liquidity in the market.
- Higher deposit rates can impact banks’ lending rates, as they seek to balance profitability and competitiveness.
- Overall, there is a direct correlation between monetary policy adjustments and the movement of deposit rates in the banking sector.
4. Comment on the competitive dynamics among banks and their effect on lending rate adjustments.
- Competition among banks influences lending rates, with banks adjusting rates to retain market share.
- In the first half of 2024-25, lending rate transmission peaked due to competitive pressures.
- However, banks later reduced spreads to attract customers, slowing the rate of transmission.
- Competition can lead to disparities in how quickly banks respond to policy rate changes.
- Overall, competitive dynamics can create a complex environment for effective monetary policy transmission.
