From UPSC perspective, the following things are important :
Prelims level : Monetary policy basics
Mains level : Monetary Policy transmission issues; Interest Rate and external benchmarks
The Reserve Bank of India (RBI) has mandated banks to link all new floating rate loans extended to both retail consumers as well as micro and small enterprises to an external benchmark.
- The external benchmark could be either the repo rate or the yield on the three- or six-month Treasury bill or any other benchmark interest rate published by the Financial Benchmarks India Private Limited (FBIL).
- This move comes after the MCLR regime has failed to improve the transmission of monetary policy.
- Even though the policy rate was slashed by 75 basis points between February and June 2019, lending rates declined by only 29 basis points during the same period.
It might lead to faster transmission of monetary policy.
- Mandating external benchmarking of lending rates could lead to interest rate risks because it will cut the link between bank deposit and lending rates.
- Bank interest margins will be stressed when interest rates are falling, as lending rates will fall faster than deposit rates.
- Banks may increase the spread allowed to charge over the benchmark rate to cut the risks.
- It may also lead to banks wanting to link their deposit rates to an external benchmark. This may hurt the depositors as they may prefer the option of having fixed rates.
- There is also the issue of small savings instruments. These rates are more static as compared to bank deposit rates and banks will face greater competition when interest rates are going down. It could lead to a flight of deposits.
- The issue of which benchmark to adopt. There may be a preference for the repo rate as yields on T-bills tend are more volatile in nature. But any sudden shock to the system could push up short-term yields sharply and have to be transmitted to borrowers.
- Instead of mandating external benchmarking, a preferable option would have been to allow banks to gradually move towards this framework.
- The State Bank of India has already linked its savings deposit and short-term loans to the repo rate. Such voluntary moves could have, over time, forced others to follow suit.