The most visible among the above is the interest rate channel. Commercial banks, from whom the RBI directly borrows, and lends to, should be among the first to change their rates in tune with the market. They would in turn lend to borrowers on the corporate and retail side. Here, the operative rate shifts from the repo rate to banks’ base rate. Banks base rate (below which they cannot lend) is determined by their cost of money (deposits), competition, credit quality of the borrowers, and balance sheet requirements.
So, the base rate is designed to be always above the repo rate, and blended deposit rates to be below the base rate leading to the spread or Net Interest Margin (NIM) of the bank. As repo rates are cut by the RBI, deposit rates are first cut by banks, which marginally lead to cut in base rates. Cumulatively, the banks have passed on between 40 – 70 bps of the total 125 bps cut in the repo rate. The floating interest rate loans such as home loans which are offered to the retail consumer are a summation of the base rate of the bank and a fixed spread. Hence, a repo rate cut transmits into a lower interest rate loan for the consumer. However, the extent of benefit varies from bank to bank and depends on the speed of transmission and pass through to the consumer.
For a typical borrower for a small home loan, we take Rs. 25 lakhs as the loan amount, and compare the impact of change in the interest rate on the EMI (Equated Monthly Installment) of the borrower, with the total reduction in the base rate of SBI in addition to the 3% (300bps) home loan credit spread for a period of 20 years, and the scenario where the base rates are cut as much as the repo rate, as shown in the table:
We can notice from the table above that the potential savings for the home loan borrower can be much more, if a bank cut their base rate by the same extent as RBI has cut the repo rates, which is a total of 125 bps, or in terms of savings in EMI – Rs. 2,425.
However, for a variety of reasons, banks have not cut their base rates to the same extent. The three main reasons are fixed formula for calculating base rate, competition, and balance sheet requirements of profitability in terms of NIM. One of the main competitors for bank deposits, are the small savings schemes like Indira Vikas Patra, etc. There, the administered rate is still higher, and the government together with the RBI has promised to look into that, as well as moving the formula for base rate calculation more to emphasize marginal cost.
What remains as a bugbear is the NPAs (Non-Performing Assets) in the banking sector. These are loans that have either gone bad, are restructured, or are restructured and gone bad. Not only is the money already lent, not coming back to provide for fresh loans; but the banks have to make funds available to create a provision against those stressed assets. This squeezes their profitability and NIMs considerably. In order to maintain their attractiveness for investors, the banks do not lower the deposit and the base rates to that extent, thereby protecting the NIMs. Banks also need to raise huge money from investors, and hence they also have to keep their profitability attractive.
Although the base rate formula, and the administered small savings rates will be adjusted by the RBI and the government to push banks to lower their base rate, the NPA problem will only fully be tackled by economic growth coming back into the system. As economic growth picks up, borrowers do well, pay off their loans, and the NPA problem reduces as a percentage of the book size of the bank. One key aspect of economic recovery is lower interest rates, and the RBI in this policy therefore cut repo rate by an aggressive 50 bps in part to kick start an aggressive base rate reduction by the banks. Only then will borrowers and consumers gain the full benefit of the rate cutting cycle by RBI, as full transmission happens.
