Tamal Bandyopadhyay: The death of the bank rate

If Reddy goes on hiking the reverse repo rate, we may see the bank rate and the reverse repo rate converging.

Yaga Venugopal Reddy's mid-term review of the monetary policy, for all practical purpose, signalled the death of the Reserve Bank of India's (RBI's) most potent signalling device "" bank rate.

The last time the bank rate was tinkered with was in April 2003, when it was brought down by 25 basis points (one basis point is one-hundredth of a percentage point) to its three-decade low level of 6 per cent.

Since then, the bank rate has not been touched upon even though the short-term reverse repo rate has progressively been jacked up. Between October 2004 and now, the reverse repo rate has increased by 75 basis points in three stages "" from 4.5 to 5.25 per cent. With this, the gap between the bank rate and the reverse repo rate has been halved "" from 1.5 percentage point to just 75 basis points.

If Reddy goes on hiking the reverse repo rate in stages to tackle the inflationary expectations, we may see the bank rate and the reverse repo rate converging. What will the RBI do at that stage?

The reverse repo rate is the rate at which banks park their short-term excess liquidity with the RBI. When the RBI pumps in short-term liquidity into the system, it charges the banks repo rate, which has now been pegged at 6.25 per cent "" one percentage point higher than the reverse repo rate. So, we now have multiple policy rates "" the repo at 6.25 per cent, the bank rate at 6 per cent and the reverse repo rate at 5.25 per cent.

The bank rate was earlier the refinance rate at which banks used to draw down liquidity support from the RBI. However, this has now been delinked for the refinance rate. It is only used for the RBI's ways and means assistance (WMA) to the Central and state governments. In other words, it is the rate for government financing.

And, it now seems to be emerging as the government nod or licence for banks to hike their deposit and lending rates. Unless the bank rate is hiked, commercial banks will not "openly" talk about raising their lending and deposit rates even though they would do so quietly every time the reverse repo rate goes up.

The RBI (in consultation with the government) will not hike the bank rate because it does not want to be seen to be officially encouraging banks to raise their rates even though it knows well that the rates cannot remain low forever.

Theoretically, the bank rate is positioned as a forward-looking statement on the RBI's views on interest rates in the medium term, while the reverse repo rate is a short-term signalling device. But how "medium" is the medium-term view and how "short" is the short-term outlook?

For instance, while announcing the policy, Reddy had said that the latest reverse repo rate hike should see the RBI through till the beginning of the next fiscal year, barring unforeseen developments. Now, isn't that a medium-term view? Similarly, between October last year and now, the reverse repo rate has been hiked thrice after a gap of every six months. Don't these short terms collectively make a medium term?

The fact of the matter is the RBI recognises that the rates will go up but refuses to admit it officially by resorting to a bank rate hike. The banks respond to the moral suasion of the regulator and feel too embarrassed to officially hike their rates. So, both the lending rates and the deposit rates of banks creep up slowly and quietly.

How does that happen? Normally, there is no announcement for hiking the deposit rates but the card rates or the rack rates become meaningless as banks allow themselves to be arm-twisted by influential corporate customers, who invariably extract 25-50 basis points higher interest rates when they park their money with the banks.

Similarly, there is no change in the prime lending rate (PLR) "" the rate at which banks are expected to lend to their prime borrowers. However, the sub-PLR rates will go up. In other words, the spread between the PLR and the actual lending rate will shrink.

For instance, a corporate customer who was accessing loan at 4 per cent below PLR (that is, 11 per cent minus 4 per cent = 7 per cent) will now get loans at 3.5 per cent below PLR (that is, 11 per cent minus 3.5 per cent = 7.5 per cent).

This is a chain process and it will not end till the RBI officially gives a thumbs up to the rate hike. Otherwise, the regulator's bank rate will go the commercial banks' PLR way "" it has become irrelevant and out of sync with the reality.