Friday, May 15, 2009

Monetary policy transmission challenge

The Fed may have lowered the federal funds rate to virtually zero, but the real rates faced by various private decision makers - credit cards, car and other personal loans, mortgages, municipal bonds, corporate bonds etc - remains high, more so since inflation has also fallen. The monetary policy may have been notionally expansionary, but has in real terms been anything but.

This is similar to the challenge facing the monetary authorities in India, though the underlying reasons vary. Though the Reserve Bank of India (RBI) has cut the short-term repo rates by 425 basis points since mid-September and the reverse repo rate by 275 basis points, it has hardly offered any relief to borrowers. As is clear from the figure below, the benchmark prime lending rates (BPLR), a reference rate for bulk of loans, banks haven’t reduced their lending rates even by half as much as the reduction in policy rates, with private and foreign banks being far slower in cutting their benchmark rates.

The credit squeeze has also led to other structural distortions in the credit pricing mechanisms. Though the BPLR is a floor rate, charged to borrowers with highest credit ratings or prime customers, banks have been charging top-notch corporate steep discounts below BPLR and retail borrowers or SMEs well above the benchmark. With the bulk of loans being advanced below BPLR, the BPLR has become a "non-transparent tool of credit pricing" and impedes the smooth transmission of monetary policy signals. The band within which the lending rates vary, for different categories of customers with similar credit profile, is too large to be reflective of a sound credit pricing market.

Update 1
All banks will have to adopt the 'Base Rate' system in place of the current Benchmark Prime Lending Rate (BPLR) system from April 1, 2010. The Base Rate, applicable for all new loans and for those old loans that come up for renewal, will be the minimum rate for all commercial loans and banks will not be permitted to resort to any lending below this rate.

Base rate will comprise cost of deposits, adjustment for the negative carry in respect of CRR and SLR, un-allocable overhead cost for banks and profit margin, among others. The RBI has said that the actual lending rates charged to borrowers would be the Base Rate plus borrower-specific charges, which will include product-specific operating costs, credit risk premium and tenor premium.

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