RBI panel headed by Janak Raj reveals ad hoc, arbitrary practices by banks to inflate interest rates

Reserve Bank of India (RBI) panel on an external benchmark rate for banks headed by Janak Raj, Principal adviser of Monetary Policy Department has submitted its report. As per the report, several disconcerting banking practices, including violation of the RBI guidelines, inflating of base rate and arbitrary adjustment of spreads are prevalent among major banks in India.

Basic Understanding of Base Rate & MCLR:

Marginal Cost of Funds Based Lending Rate (MCLR), introduced by RBI from April 1, 2016 is the minimum interest rate of a bank below which it cannot lend.

• It serves as an internal benchmark for the bank. Interest rate on corporate and retail loan products is fixed above this rate. Higher difference between benchmark rate and loan rate is more beneficial for the bank from revenue standpoint.
• MCLR was introduced to replace the base rate mechanism. However only around 40 per cent of the corporate portfolio and one-fourth of retail portfolio are currently under the MCLR regime.

Observations by RBI panel:

It has been observed that banks deviated in an ad hoc manner from the specified methodologies for calculating the base rate and MCLR.

• This was done either to inflate the base rate and MCLR or prevent it from falling in line with the actual cost of funds.
• The inflated MCLR results in fixing higher interest rates on various loan products viz. home loans, automobile loans and corporate loans at inflated levels despite the sustained cut in the repo rate by the RBI which brings down the actual cost of funds for the banks.
• Since December 2014, RBI has cut the repo rate by 200 bps. However, on an average the base rates of banks have declined by only 75 bps.
• Passing on the benefit of Repo Rate cut has been significant on new loans (especially home loans) as compared to outstanding loans.
• The panel report also stated that effective interest rate burden on the borrower has remained the same even after switching to the MCLR regime from the base rate regime since April 1, 2016.