Model Answer
0 min readIntroduction
Monetary transmission refers to the process through which changes in the policy rate (repo rate) set by the Reserve Bank of India (RBI) are passed on to lending rates of commercial banks, and ultimately affect borrowing costs for businesses and consumers, influencing economic activity. However, this transmission mechanism in India has historically been weak and incomplete. The RBI, recognizing this, has been pushing for greater reliance on external benchmarks for pricing loans, culminating in the recent guidelines mandating linkage to external benchmarks like the Marginal Cost of Funds based Lending Rate (MCLR) and the Treasury Bill (T-Bill) rate. This move aims to improve the efficiency of monetary policy transmission and enhance economic growth.
Why Monetary Transmission is Not Effective in India
Several factors contribute to the weak monetary transmission in India:
- Imperfect Competition in Banking Sector: A significant portion of the banking sector is dominated by Public Sector Banks (PSBs) which often prioritize social banking objectives over pure profit maximization, leading to slower pass-through of policy rate changes.
- High Proportion of Non-Performing Assets (NPAs): Elevated levels of NPAs constrain banks’ ability and willingness to reduce lending rates, as they focus on maintaining profitability and capital adequacy. According to RBI data (as of March 2023), the Gross NPA ratio of Scheduled Commercial Banks stood at 4.82%.
- Sticky Deposit Rates: Banks are often reluctant to reduce deposit rates, even when the policy rate is lowered, as it can lead to deposit outflows. This reluctance limits their ability to lower lending rates.
- Liquidity Conditions: Persistent liquidity mismatches in the banking system can hinder effective transmission.
- Base Effect & Structural Issues: The base effect, where previous rate cuts are already factored into lending rates, can diminish the impact of subsequent cuts. Structural issues like high cost of funds and operational inefficiencies also play a role.
- Limited Credit Demand: Weak credit demand, particularly from the private sector, reduces the incentive for banks to lower lending rates.
Comparing Efficacy: External vs. Internal Benchmarks
Historically, banks in India primarily used internal benchmarks like the Base Rate and MCLR to price their loans. The RBI has now encouraged a shift towards external benchmarks.
| Feature | Internal Benchmarks (MCLR) | External Benchmarks (Repo Rate/T-Bill Rate) |
|---|---|---|
| Responsiveness to Policy Rate Changes | Less responsive; banks have discretion in adjusting MCLR. | More responsive; rates adjust automatically with changes in the external benchmark. |
| Transparency | Lower transparency; calculation methodology can be complex. | Higher transparency; benchmarks are publicly available and easily understood. |
| Competition | Limited competition; banks can collude to maintain higher rates. | Increased competition; forces banks to price loans competitively. |
| Transmission Lag | Longer transmission lag; rate adjustments are delayed. | Shorter transmission lag; rate adjustments are quicker. |
| Impact of Liquidity Conditions | Less affected by short-term liquidity fluctuations. | More directly affected by liquidity conditions. |
Recent RBI Announcements & Their Impact
The RBI’s recent announcements, including the mandatory linking of floating-rate loans to external benchmarks, are aimed at improving monetary transmission. Specifically:
- Mandatory Linking: All new floating-rate loans for individuals and MSMEs are now linked to an external benchmark.
- Risk Premium: Banks are allowed to charge a risk premium over the external benchmark, but this premium is subject to regulatory scrutiny.
- Review of Benchmark Rates: Banks are required to review their benchmark rates periodically.
These measures are expected to lead to faster and more complete transmission of policy rate changes, making monetary policy more effective. However, the effectiveness will also depend on factors like credit demand and the overall economic environment.
Challenges to Effective Transmission even with External Benchmarks
Despite the shift to external benchmarks, challenges remain:
- Spread Management: Banks may try to maintain their net interest margins by adjusting spreads rather than reducing lending rates directly.
- Credit Risk Assessment: Banks may be hesitant to lower rates for borrowers perceived as high-risk.
- Competition Concerns: The degree of competition in the banking sector remains a factor.
Conclusion
While the shift towards external benchmarks represents a significant step towards improving monetary transmission in India, it is not a panacea. The effectiveness of this policy will depend on addressing underlying structural issues in the banking sector, such as high NPAs and liquidity mismatches, and fostering a more competitive lending environment. Continuous monitoring and further regulatory refinements will be crucial to ensure that monetary policy effectively contributes to economic stability and growth. The RBI’s ongoing efforts to enhance transparency and promote competition are vital for realizing the full potential of external benchmarking.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.