Is the bank rate still relevant?

Sanjeet Singh
Head, Fixed Income Research,
ICICI Securities Ltd

The question of relevance begs an objective or context. It can be argued that bank rate is not relevant viewed from the objective of monetary policy setting. Nevertheless, it holds significance in many ways. In recent times, however, its mode of usage and the attendant spin have raised a number of issues.

The Indian central bank is invested with two informal objectives of growth and price stability. Since there is a short-run trade-off between real growth and inflation and both get affected in the short run by a single rate decision, multiplicity of rates or instruments for achieving this trade-off is not needed. By its own admission, the Reserve Bank of India (RBI) expects to contain inflation and inflationary expectations by moving LAF rates. That being the case, bank rate is simply extraneous. If containment of longer-term inflation expectation is crucial, accumulated credibility and LAF decisions could together ensure that.

Looking at the issue conceptually, what does a rate that supposedly moves in response to medium-term inflation expectations of a central bank really imply when it does move? Theoretically, it suggests a central bank not only behind the curve but expecting to stay so. Additionally, no central bank can set rates looking at its own medium-term inflation expectations divorced from consumers' or producers' expectations. In practice and literature, it is agreed that a central bank must change rates if households' expectation is changing fast, even if the bank's medium-term view does not.

Further, sending periodic signals on medium-term inflation and rates through bank rate constitutes an intervention in or recommendation for trade in medium- and long-maturity bond prices. With their simultaneous conventionally-established connotations for loan rates, bank rate signals inadvertently end up as all-too-frequent interventions by the RBI in asset markets. This goes against the grain of market-based economics.

Finally, multiple rates can lead to distorted signals and faulty market perceptions. The RBI's recent comments suggest certain sanctity about the 6.0 per cent figure. This unwitting advertisement of a single numerical value for medium-term rates places RBI's credibility on stake for no great economic gains. For, though this is most open to argument, low real rate regime seen in the last two-three years worldwide and in India may be at risk going forward. An unchanged bank rate of 6.0 per cent in an economy growing 12-13 per cent nominally actually corresponds to this kind of regime. It may not be advisable for the central bank to be seen so deeply wedded to this figure.

The bank rate suffers from various conceptual and contextual drawbacks. Instead of signaling, it serves to befuddle; many a time it leaves a smoke of ambiguity and tentativeness around rate decisions and undermines policy efficacy. Possibly, it is time for reassessment of its role in the monetary policy.

Views expressed are strictly personal.

K Cherian Varghese,
CMD, Union Bank of India

There is a debate going on as to whether bank rate is still relevant. The Reserve Bank of India (RBI) has not changed this benchmark rate of interest for a long time and has been focusing more on changes in the reverse repo and repo rates to send signals to the market.

The reverse repo rate is the rate of interest which the RBI pays to commercial banks when they keep their temporary excess funds with the central bank. Repo rate is the rate of interest charged by the RBI for borrowings made by the scheduled banks to meet their liquidity requirements.

The reverse repo rate was increased from 5 to 5.25 per cent and the repo rate from 6 to 6.25 per cent in the mid-term review of the monetary policy announced on October 25. The reverse repo and repo rates are interest rates paid or received on overnight funds. And the rates on overnight funds may not entirely reflect the central bank's stance on interest rates.

Bank rate used to be the rate of interest charged by the RBI on borrowings made by the scheduled commercial banks as refinance. The bank rate is retained at 6 per cent in the recent mid-term review.

Those who argue against the relevance of bank rate may say that there may be conflicting signals on the rate of interest from the central bank as the repo rate is raised to 6.25 per cent while the bank rate is maintained at 6 per cent. One may not agree with this argument because the repo rate signifies a very short term view while bank rate may indicate a medium term perspective. Repo rate may be seen as a balm applied externally to relieve the pain of overnight excess liquidity, while bank rate may be perceived as a medicine for internal consumption, which will stabilise the financial system over a longer period.

Long back in the past all lending rates of commercial banks were linked to the bank rate. Any change in the bank rate had an immediate impact on the entire interest rate structure of the banking system. With the introduction of the prime lending rate (PLR) and the Sub-PLR system of pricing credit, bank rate has lost some of its glitter. However, as a benchmark which is set by an impartial authority, bank rate still commands respect. And a central bank speaks its mind not necessarily through directives always. It can send a clear signal to the market on its stance on interest rate through a change in the bank rate. The bank rate unlike its younger cousin, the repo rate could be a more powerful player and can move the market as and when the RBI wants. And we need a benchmark rate, which will speak out the central bank's mind on interest rates in the medium term. As of now the bank rate remains the signaling device until it is replaced by some other benchmark.