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RBI panel reveals ad hoc, arbitrary practices by banks to inflate interest rates
October, 10th 2017

The Reserve Bank of India (RBI)’s study group, which recently submitted its report on an external benchmark rate for banks, has revealed several startling and “disconcerting” banking practices, including violation of the RBI guidelines, inflating of base rate and arbitrary adjustment of spreads. Such malpractices, in turn, aided banks in fixing interest rates on various loan products, including home, automobile and corporate loans, at inflated levels despite the sustained cut in the repo rate by the RBI.

While the transmission to interest rates on fresh loans (mainly home loans) was significant, it was muted to outstanding loans (base rate and MCLR). The analysis said that banks deviated in an ad hoc manner from the specified methodologies for calculating the base rate and the MCLR to either “inflate the base rate or prevent the base rate from falling in line with the cost of funds”. This led to an inappropriate calculation of the cost of funds and no change in the base rate even as the cost of deposits declined significantly.

In other words, even when the RBI has cut repo rate by 200 bps since December 2014, EMIs on home and other loans failed to come down for old customers. Between January 2015 and August 2017, the median base rate of banks declined by only 75 bps against 158 bps decline in the banks’ median term deposit rate, and 195 bps decline in the weighted-average domestic term deposit rate. The study group, headed by Janak Raj, principal adviser, Monetary Policy Department, included four chief general managers from various departments of the RBI.

Even after 18 months of its introduction, in most banks, only around 40 per cent of the corporate portfolio and one-fourth of retail portfolio are under the MCLR regime. “A few banks made little effort to migrate small and retail customers from the base rate system to the MCLR regime, as there was no proper dissemination of switch-over option through the branches of the banks or their websites. A number of banks levied a one-time switch-over fee on migration of advances from the base rate to the MCLR regime,” the RBI’s panel on new benchmark said.

Moreover, it was observed that the effective interest rate burden on the borrower remains the same even after switching to the MCLR regime from the base rate regime. In a few cases, interest rates were raised by as much as 300 bps. “The calculation methodology followed by banks raises some concerns: Some banks had inflated the return on networth (RoNW), which was neither in tune with market conditions nor with their track record,” it said.

Some banks did not have a cost accounting system for their loan products and loaded the entire operational cost — components such as clearing house rent, corporate social responsibility spending — which were not directly associated with lending, thereby overstating the operating costs. “The definition of operating cost followed by some banks was not in accordance with the guidelines prescribed by the Reserve Bank,” the panel said.
A large portion of increase in CASA (current accounts, saving accounts) deposits after demonetisation was not considered as a core component of deposits by a bank, it said. Another bank computed the MCLR for one-year tenor, even though it was not the single-largest maturity bucket for the total funds. “Some banks considered a lower part of saving deposits as core deposits for computation of marginal cost of funds. Some banks determined tenor premia/ discounts subjectively in the absence of any method/market benchmarks. Some banks have not reviewed tenor premia/ discounts determined since March 2016,” it said. In the case of one bank, loan pricing was determined based on fund transfer pricing instead of being determined as per the mandated base rate/MCLR methodology, the panel said.

The panel said many banks indulged in arbitrary adjustment of spreads. The large reduction in MCLRs by some banks was partly offset by an increase in the spread in the form of business strategy premium. “This happened in the case of housing loans and unsecured personal loans, among others. Some banks did not have a board approved policy for working out the components of the spread charged to a customer,” the RBI panel said.
In the case of some banks, there was no concept of a “spread” as envisaged in the extant Reserve Bank’s guidelines. Instead, it was only a balancing figure that resulted from the difference between the final rate calculated as per the bank’s own internal interest rate framework and the MCLR calculated by the bank. “Some banks defined risk premium such that the variable component of the business strategy premium was added to the credit risk premium. This allowed them to vary the spread in a range of about 475 basis points for advances to various sectors,” the RBI group said.

According to the panel’s findings, for calculating the cost of deposits/funds, one major public sector bank took average of the card rates of retail term deposits (7 days to 1 year) only, ignoring fully the low cost CASA deposits [current account (no interest cost) and saving account (interest cost of 4 per cent)], which formed a significant portion of the total deposits of the bank. “Another major public sector bank kept the base rate unchanged between September 2016 and March 2017 even as its cost of deposits declined by around 40 bps. The bank, however, increased its return on net worth by almost 45 bps; as a result, the base rate remained unchanged,” it said.

The actual base rate worked out by one major private sector bank in March 2017 was almost 80 bps higher than suggested by the base rate formula. In April 2017, the bank’s actual base rate was close to the formula, as the bank tweaked the formula-based base rate, by adding two new components to the formula.

While the RBI panel has proposed that one of the 3 instruments — Treasury Bill rate, the Certificate of Deposit rate and the repo rate — can be selected as the external benchmark rate to ensure that borrowers, especially home loan customers, get the benefit of rate cuts by the central bank, banks are not very happy about the observations. When asked about the RBI report, the Chairman of a top public sector bank said, “We will study the report and give our comments. The benchmark rate will apply to both assets and liabilities. It can’t be a one-sided affair. Any margin (NIM) will need to be sufficient to take care of credit costs.”

“The pricing of the loan product and liability product will have to move in tandem… to reduce the lending rate without reducing the deposit rate is not possible. We cannot ignore the interests of depositors. Whatever is the pricing regime, we are all for transparency. We are committed, if we are having any cushion whatsoever, to pass on any benefit to the customers,” he said.

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