Repo Rate cut-Impact; RBI proposes formula to calculate Base Rate; Monetary Policy Transmission

Contents

• Repo Rate cut by 50 basis points
• Impact of repo rate cut on various sections of society.
• RBI proposes formula to calculate Base Rate (Sep 2015)
• Monetary Policy Transmission

Repo Rate cut by 50 basis points (Sep 29, 2015)

Indicator	Current rate (Oct 13, 2015)
SLR	21.50%
Repo rate	6.75%	Visit mrunal.org for basics
Reverse repo rate	5.75%
Marginal Standing facility rate	7.75%

Repo rate = rate at which banks borrow money from RBI.

100 Basis points = 1%.

RBI cut repo rate by 50 basis points or 0.5%.

Impact of repo rate cut on various sections of society.

Sections of society	Impact
Banks	RBI loans for banks became cheaper. Banks can borrow more money from RBI and lend this money as home loans, car loans, business loans etc. at comparatively cheaper rate. More people take loans as interest rate is low and banks make good profit.
Depositors	Interest rate on deposits will fall. So depositors will get less interest on their deposits. [Bank needs money to lend. The money comes from deposits and/or RBI lending. When repo rate is high, banks depend on deposits. So depositors will get more interest on their deposits. When repo rate is low, banks depend on RBI. So depositors will get less interest on their deposits ]
Borrowers	Banks will slowly reduce interest rate on borrowing. So loans become cheaper.
Business	Cheap loans available for business. Business will thrive and there will be more new businesses.
Jobs	More business = More jobs
Poor	Low repo rate = more money in economy = more inflation = things are more costly. Low repo rate = more jobs. But this is not immediate. So not much beneficial. Low repo rate = people buy more = poor vendors, small kiranas will benefit. [They don’t usually depend on formal banking sector for financial resources. So they don’t reap quick benefits of low repo rate]
Middle class	Usually benefit from low repo rate as they are better connected to financial sector.
Rich	They benefit hugely. More money for business, more investment in alternative investment instruments (mutual funds, share market, etc.).

RBI proposes formula to calculate Base Rate (Sep 2015)

Understanding base rate

• The base rate was designed to replace the flawed benchmark prime lending rate (BPLR).
• BPLR was minimum rate at which banks could lend to its customers. The calculation of BPLR had no uniformity and banks were able to subvert the norms.
• The bulk of wholesale credit (loans to corporate customers) was contracted at sub-BPL rates and it comprised nearly 70% of all bank credit.
• Under this system, banks were subsidizing corporate loans by charging high interest rates from retail and small and medium enterprise customers.

Base Rate system introduced

• In October 2009, the central bank decided to move all banks to a new interest rate system, which would be transparent.
• Now, banks will not be allowed to lend below this Base Rate.
• Under the new rule, banks were free to use any method to calculate their base rates provided the RBI found it consistent.
• Banks were also directed to announce their base rates on their Websites, in keeping with the objective of making lending rates more transparent.

Why RBI wants to propose new formula

• To bring in uniformity among banks for calculation of base rate.
• To make lending rates sensitive to the policy rate.

How is Base Rate calculated at Present?

• At present, banks follow different methodologies for computing their Base Rate.
• While some use the average cost of funds method, some have adopted the marginal cost of funds while others use the blended cost of funds (liabilities) method. [No Need to know about these terms unless you are preparing for RBI Exam]
• It was observed that Base Rates based on marginal cost of funds are more sensitive to changes in the policy rates.
• In the first Bi-monthly Monetary Policy Statement this fiscal the RBI had stated that in order to improve the efficiency of monetary policy transmission, it will encourage banks to move in a time-bound manner to marginal-cost-of-funds-based determination of their Base Rate.

Monetary Policy Transmission

• Monetary policy transmission: The changes made by RBI to its quantitative tools (Repo rate, reverse repo rate, SLR, CRR) will reflect accordingly in the money market. Policy transmission may be quick or slow.
• In India Monetary policy transmission is very slow. In USA it is very quick.

But why?

• Because RBI is not the only source of money for banks. The biggest source of money for banks are its depositors.
• In India, people don’t invest much in alternative investment instruments like mutual funds, hedge funds, shares etc. They stock their savings in banks.
• So banks will have plenty of money left even if RBI increases or decreases repo rate.
• This is why banks don’t quickly reduce or increase their lending rate according to changes in repo rate. (this behavior of banks result in inadequate monetary transmission which makes RBI very angry)
• In USA people invest more in mutual funds, shares etc. and deposit very little in banks.
• So banks in USA are completely dependent on Federal Reserve System for money.
• Hence policy rate transmission is quick in USA.

When there is rate cut, banks reduce lending rate by a small percent whereas deposit rate by a large percent. Why?

• According to a rating agency, banks on average have reduced their fixed deposit rates by 130 basis points (1.30 percentage points) while reducing the lending rates by only 50 basis points (0.50 percentage point).
• The reason is that barring some large customers, bank depositors have no other option to invest their savings outside banks.
• The latter category includes senior citizens and those who depend entirely on interest income from banks (Lack of financial literacy).

How is it that banks are still hopeful of retaining, perhaps even growing their deposit base at a time of falling rates?

• Small savers may not have an option to go elsewhere but apparently there is plenty for the rich — the high net worth individuals (HNI) and corporate depositors.
• How many of us know that bulk deposits (usually one crore and above) fetch a higher interest rate.
• And in the capital market too, despite lip service paid to them, small investors are a neglected lot. Most of them have kept away from recent IPOs.
  

  
  

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