Benefits of monetary policy transmission limited

A competitive exchange rate will help businesses more than lower lending rates, says A V Rajwade

From the monetary policy statement and post-policy interview of the Governor, it is evident that he was not happy that the last two interest rate cuts administered by the central bank were not reaching the borrowers through a reduction in the banks’ base rates: with credit demand low, a drop in the base rates of commercial banks may help spur it. He has also been quoted as saying that, “In most countries you don’t have a situation in which banks decide what the rate... should be: it is a market-based rate. We need to move towards that.” I imagine that the reference to “most countries” is to the advanced industrial economies, and more so the two major Anglo-Saxon countries which boast of “deep and sophisticated financial markets”. It has also been argued that banks should calculate their base lending rate on the marginal cost of funds, rather than the average cost.

On first principles, the interest which any financial intermediary would charge the borrower would consist of:

• The cost of funds (including administrative costs);
• Compensation for the credit risk; and
• The desired return on capital.

As for the first, having studied the subject of asset: liability management in some detail, it is difficult for me to believe that the marginal cost of funds can be the basis for calculating the base lending rate, when the bulk of the commercial assets of the banking system are in the form of overdraft or cash credit accounts, rather than in the form of loans with specific interest rates and maturity dates. In the latter system, which is very prevalent in countries like the US, the marginal cost can be a greater influence on the interest rate on new loans, while the existing loans continue at the old rates until maturity. In my view, given that administrative costs are broadly immune to interest rates, the average cost of funds would need to be given far greater importance than the marginal cost.

As for the second point, namely compensation for the credit risk, the “deep and sophisticated” markets made a total mess of credit risk pricing of structured credit derivatives, leading to the financial crisis of 2008. One also recalls that, when the savings and loans industry in the US (housing finance companies) moved from regulated to market-determined interest rates, there was a major crisis in the late 1980s/early 1990s.

In India, for one thing, there is no term inter-bank market: the industry is also facing a growing proportion of non-performing assets, particularly in the infrastructure sector – not so much because of “crony capitalism” between businessmen and bankers (those ties are far stronger between Wall Street and Washington), as because of delayed project implementation thanks to the regulatory maze, and the difficulties of doing business in India. And, the losses on NPAs need to be recovered through earnings on performing assets.

The third issue, namely the desired return on capital, has become larger as a result of the Basel III capital charges, a direct fallout from the financial crisis of 2008. While the increased capital charges were meant to strengthen the banking industry, they would ultimately be paid for by the real economy through interest costs higher than what they otherwise would have been. In any case, for this analyst, their efficacy in avoiding bank runs is questionable. One wonders how many individual depositors look at the capital ratios while opening accounts – or closing them in a rush when confidence is lost. It should not be forgotten that, Northern Rock, the first bank to face a run on its deposits in 2007, had the highest capital ratio amongst all British banks.

To come back, many banks seem to have been “persuaded” to reduce base lending rates after the policy. The question is whether this makes a meaningful difference to corporate margins. The financing cost of the 500 largest listed companies is of the order of 3% of the top line; a quarter percent drop in the interest rate may bring this down to perhaps 2.95%!
A more competitive exchange rate will help businesses far more.

Email: avrajwade@gmail.com