Dynamic base rate will be dynamic when rates go up as well!

There is a lot of clamour over the upcoming new regime for setting interest rates in India. This will shift the basis of setting rates from average cost basis to marginal cost basis. So far banks were pricing their loans on average cost basis. As average costs take longer to change, it took that much more time to pass on changes to loan rates.  With marginal cost in play, things will be much  faster.

Let’s see how this will work using stylised balance sheets. A bank’s bal sheet looks like this:

Liabilities Assets
Deposits Loans
Borrowings Investments
  • The total costs here are the interest rate costs the banks pay on its liabilities – deposits + borrowings.
  • The average costs will be total cost divided by the amount of money borrowed. Based on these costs, the banks price their loans. If the average costs decline, the banks will try and lower the loan rates and vice-versa. As we can figure, average costs take longer to change as it is average! The volume of newer funds  at a newer rate has to be more than the older funds at an older rate. Then only the average costs will come down. This takes time and hence so called monetary transmission takes time.
  • The marginal costs are expected to change this slow game and make it more dynamic. Marginal cost mean change in cost due to change in one unit of production. Here the production is collection of funds. So, the marginal cost will mean change in interest rate costs due to a new deposit/borrowing. As we can see, this marginal cost will respond much quickly to policy rate changes. Say a central bank lowers policy rate, first cost of new borrowings will decline followed by new deposits. This will push the marginal costs lower right away. The idea is to now price the new loans based on this marginal cost. The bank need not wait for the average costs to come down. The new borrowers can benefit much quicker.

So this is pretty much the basis for new regime. The monetary transmission is likely to be quicker. However, this are not as easy as they are made out to be.

There are two questions around this transmission:

  1. First, have banks changed the policy rates in line with central bank policy? This means when central bank eases the policy, have banks eased as well?
  2. Two, have the banks changed the magnitude of policy in line with central bank magnitude? This means when central bank has cut policy rates by 100 bps in the year, how much have the banks complied.

The problem is not really with the first as banks usually follow the central bank. The problem is more with the latter as there is often criticism that banks have not passed on the full rate cuts as the central bank.  This is the hot question and criticism on Indian banking today as well. But then it is difficult to equate a bank with that of a central bank. A bank is a business entity and has to make adjustments to a policy change. It just can’t shrug its old liabilities as the central bank wishes. A central bank  has no such business angle and can change policy rates at mere drop of a hat. There are no balance sheet or profit angle for a central bank but with banks there are multiple such angles. Banks cannot react as the central bank reacts.

And then will the reaction  be the same once the central bank begins to hike rates as well? New loans then are likely to become costlier much quickly. As it is there is another criticism that banks are slow to pass rate cuts but really fast to pass rate hikes. With marginal pricing, these bank rate hikes will be even more faster. The EMIs etc will rise even more quickly. How will the govt and central bank react then?

I don’t know but all this micromanagement of bank balance sheets should be done away with. The regulator should free banks from deciding their own basis of pricing just like we have in other sectors. Set a broad set of acceptable norms and let banks figure whether they want to adopt marginal/average (or operational costs) for pricing their loans. Accordingly, the consumers will decide who to shop with for banking services. By treating banks differently from other businesses, regulators and govt create more problems. Regulate but don’t over do it.

This micromanagement and standardization has its own share of unintended consequences. Like, most of the arguments around this new regime is that lower rates will benefit consumers right away. But hardly any article has argued what will happen when rates go up which will happen as oil prices again start to go up in future.

This is not something out of the blue as well. Historically, banks figured these things themselves . Yes, there were issues with some banks and they died but this happens with all other businesses as well. Overtime, we all figured what is right and what is wrong with certain products and services. Why should we expect all banks to last forever? People lose money in bad products and can lose money in bad banks as well.  But somehow we don’t encourage such thinking with respect to banks.

And then dynamism has its own share of troubles especially in banking/financial services. It is a word best avoided, It was the same so called dynamic financial sector which sowed the seeds of trouble and then eventually exploded..

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