Will RBI adopt the marginal cost-of-funds approach?

By | April 19, 2015

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When the Reserve Bank of India (RBI) reduced the repo rate by 0.25 percentage point in January 2015, it came as a pleasant surprise for millions of home loan borrowers. They were expecting the banks the follow suit and cut lending rates to pass on the benefits to customers.

Banks, though, had different plans. They were not quick to respond to the interest rate cuts citing various reasons—high cost of fund, high non-performing assets, etc, among others. The top management of the banks, however, kept the optimism among borrowers going with their media statements giving possible timelines for rate cuts.

The RBI cut the repo rate again by another 0.25 percentage point on 3rd February. This time the borrowers were sure that the interest rate burden on them would finally be lightened. That wasn’t to be, though.

Banks continue to come up with the same alibis for not bringing down the interest rates for customers. It took some hard talk by the RBI and the government for banks to relent and finally cut lending rates.

So, after the first repo rate cut in January, and another cut in February, banks finally started cutting lending rates in April—almost three months after the first repo rate cut.

The marginal-cost-of-funds approach

Given the arbitrariness of bank’s rate cut decisions, the RBI has asked banks to shift towards marginal-cost-of-funds regime, in which the bank’s lending rates are more sensitive to RBI’s policy rates. This results in quick transmission of RBI’s policy rate changes to end customers.

Banks’ lending rates are benchmarked to the base rate—the rate below which it can’t lend to borrowers. The base rate is calculated in different ways—weighted average cost of funds, marginal cost of funds, etc.

While the weighted average cost of funds takes into account the interest bank is paying for all the loans, the marginal cost of funds takes into account the cost of new borrowings.

Marginal-cost-of-funds method, therefore, results in quicker transmission of the effect of RBI’s rate cuts on banks’ base rates.

Impact on borrowers

On the positive side, a shift towards marginal-cost-of-funds method means borrowers would not have to wait endlessly for banks to cut lending rates after the RBI has reduced policy rates. The benefit of lower rates would reach the end customers sooner than it does at present.

However, at the same time this will increase the volatility of lending rates. This is good when rates are falling as retail loan rates would come down more frequently than they do now. On the flip side, when the rates go up, the retail loan rates would also go up more sooner than at present.

Banks, which may not be very keen on shifting to the new method of calculating base rate, would tend to tighten its approach when it comes to fixing loan rates. While there is little scope of tinkering with the base rate, banks may always charge higher spread (the difference between the base rate and the final lending rate).

For example, a bank is offering home loan at base rate plus a spread of 0.25 percentage point, that is, if the base rate is 9.75%, the interest on home loan is 10%. If the bank cannot alter the base rate, it can always charge a higher spread, say 0.35 percentage point instead of 0.25 percentage point.

From speculation to reality

Banks would slowly have to adopt the new method of calculation of base rate, and this should benefit the customers in the next couple of years as the country is gearing for a low interest rate regime. However, as and when the rate cycle reverses, and the cost of funds increases for banks, there are possibilities of sharp increase in lending rates.

Going forward, we may also see banks facing issues such as asset-liability mismatch in absence of attractive long-term deposit rates. In such a situation, banks may be forced to tinker with the spread part of the lending rates.

But as long as we haven’t moved to the new regime (marginal-cost-of-funds method), we can only speculate. Until then, it is advantage borrowers.

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