Reserve Bank of India’s flip-flops on floating rate benchmarks

Superb post from Prof JR Varma of IIMA.

He points how RBI in 2001 had asked banks to use external benchmarks before going to internal benchmarks in 2010. In 2019, we are back to external:

These flip-flops reflect the failure of the central bank on two dimensions:

    • The failure to create a vibrant term money market with liquid benchmark rates creates dissatisfaction with external benchmarks. In 2009, the RBI Working Group justified the shift to internal benchmarks as follows:

Banks are finding it difficult to use external benchmarks for pricing their loan products, as the available external market benchmarks (MIBOR, G-Sec) are mainly driven by liquidity conditions in the market, and do not reflect the cost of funds of the banks. … Besides, the yields on some of the instruments may not suggest any representative pricing yardsticks given that they have limited volumes compared to the overall size of the financial market.

    • The failure to create a sufficiently competitive banking system means that internal benchmarks do not work well because in the absence of strong market discipline, banks do not use fair and transparent pricing of floating rate loans. The RBI Study Group that recommended the shift back to external benchmarks described the problem as follows:

First, the experiences with the PLR, the BPLR, the base rate and the MCLR systems suggest that interest rate setting based on an internal benchmark is not transparent as banks find ways to work around. Second, the interest rate setting based on an internal benchmark such as MCLR is not in sync with the practices followed in the modern banking system.

In the next few years, India needs to work on creating both a better banking system and better financial markets. One of the pre-requisites for this is that regulators should step back from excessive micro-management. For example, the RBI Master Directions require the interest rate under external benchmark to be reset at least once in three months while elementary finance theory tells us that if the floating rate benchmark is a 6-Months Treasury Bill yield, it should reset only once in six months. Either banks will refrain from using the six month benchmark (eroding liquidity in that benchmark) or they will end up with a highly exotic and hard to value floating rate loan resetting every three months to a six month rate. Neither is a good outcome.

Hmm..

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