The RBI Governor Raghuram Rajan has handed markets a bonanza by slashing the repo rate — the rate at which banks borrow short-term funds from RBI — by 50 basis points to 6.75 per cent on Tuesday, when everyone was expecting a 25 basis points cut. By lowering its inflation target for January 2016 to 5.8 per cent from 6 per cent earlier, the RBI has clearly indicated its growing comfort with falling inflation. For borrowers, this move is positive on two counts. One, given the RBI’s one year expected T-bill real interest rate of about 1.5-2.0 per cent, there is enough scope for further rate cuts, with its 2016-17 inflation target of 5 per cent. Two, by slashing the repo rate by a steep 50 basis points, the RBI has given banks enough headroom to lower lending rates in the next couple of months. Banks have already seen their cost of funds decline substantially over the past year and may now be forced to pass on some of the benefit to borrowers, particularly in view of the RBI’s recent guidelines on base rates.
Yawning gap
With the 50 basis points cut in repo rate, the RBI has reduced its key policy rate by a total of 125 basis points since January. While the bold move will set the direction for banks to reduce lending rates, the pace of transmission will be keenly watched.
In the past, banks have been tardy in passing on rate cuts to borrowers. Barring HDFC Bank, that lowered its base rate (minimum lending rate) by a steep 35 basis points last month, other banks have only reduced their base rates by 25-30 basis points. This was just half the amount by which the RBI had lowered its repo rate from January until Tuesday’s policy review.
While banks have been cutting their deposit rates aggressively over the past year, they have not passed on the benefit of the lower cost of funds to borrowers in the form of lower lending rates. One of the main reasons for this has been that banks source only a minuscule portion of their funds from the repo window and rely significantly on longer term deposits. Hence, changes to policy rates don’t immediately impact their cost of funds, particularly since banks are free to decide the way they compute their cost of funds.
Banks are currently free to calculate the cost of funds either on the basis of the average cost of funds or on the marginal cost of funds. With many banks using the average cost of funds method, the bulk of their deposits are unaffected by rate changes. When the RBI cuts rates, banks trim rates on incremental term deposits; older depositors continue to earn higher rates.
Leading banks have reduced their deposits rates by 1-1.25 percentage points across tenures over the last six-nine months, none of which has resulted in lower lending rates.
Setting it right
In a bid to force banks to transmit policy rates faster, the RBI recently proposed that banks must calculate their base rate based on their marginal funding cost from April 2016. Until now, banks could set their base rate (minimum lending rate) after determining a spread over their total costs, factoring in operating costs, cost of funds, and the minimum return on equity they deem adequate. But the banks had the option of using either the average cost of funds or the marginal cost of funds. According to the draft guidelines, banks will have to use the marginal cost of funds.
This means that banks’ margins would come under pressure, in a declining rate cycle such as now, as the decrease in lending rates would be higher than the decrease in overall funding cost. This may force banks to cut rates more sharply, which has been the intent of the RBI all along.
Relief for borrowers
While the RBI’s new guidelines for base rate computation will present challenges for some banks, it has paved the way for smoother transmission of rate action for borrowers. To add to this, the RBI’s aggressive rate cut on Tuesday, will force banks to bring down their lending rates. While each bank will decide by how much and when it will lower rates, borrowers can be assured of plenty of action in the coming months.