The Reserve Bank of India (RBI) recently reported a rise in loans pegged to the External Benchmarks Lending Rate (EBLR), such as the repo rate, from a mere 2.4% in September 2019 to an impressive 28.5% in March 2021. This leap forward indicates a significant improvement in the transmission of monetary policy. However, a substantial 71.5% of current loans remain linked to Internal Benchmark Lending Rate (IBLR), posing a continuing challenge to the effective execution of this policy.
Understanding Monetary Policy Transmission
Monetary policy transmission refers to how changes made by the RBI to the policy rate influence economic activities, including lending and inflation. The repo rate, also known as the benchmark interest rate, is defined by the rate at which the RBI lends money to banks for short-term loans.
Exploring Internal Benchmark Lending Rate (IBLR)
IBLR comprises a set of reference lending rates calculated after considering several factors, such as the bank’s current financial status, deposits, and non-performing assets (NPAs). Base rate, BPLR, and MCLR are examples of IBLR.
Understanding Different Types of IBLR
Benchmark Prime Lending Rate (BPLR) was employed as the go-to rate by banks until June 2010. Under BPLR, bank loans were priced based on the actual cost of funds. However, this system was later undermined, resulting in an opaque pricing structure.
Base Rate was the minimum interest rate at which commercial banks could lend to their customers from June 2010 to April 2016. It was derived from three parameters: cost of funds, unallocated cost of resources, and return on net worth.
Marginal Cost of Lending Rate (MCLR) has been in effect since April 2016. It is the minimum lending rate for floating-rate loans, based on four constituents: the marginal cost of funds, negative carry due to the cash reserve ratio, operating costs, and tenor premium.
Issues with IBLR Linked Loans
A significant flaw in the IBLR regime was that banks failed to pass on the full benefits of RBI’s cuts in repo and reverse repo rates to borrowers. The IBLR linked loans’ interest rates had multiple variables, hindering swift interest rate changes in alignment with the RBI’s repo rate policy changes.
Introduction of EBLR and Its Benefits
In a bid to enhance transparency and standardization, the RBI mandated banks to adopt a uniform external benchmark within each loan category starting 1st October 2019. This external mechanism assures faster implementation of policy rate cut decisions and greater transparency in interest rates.
The Way Forward
Competing higher-interest saving instruments such as small saving schemes and debt mutual fund schemes have hampered transmission, particularly during the easing cycle. In response, the government should synchronize fiscal policy with monetary policy over the long term.