The RMA, in an effort to review interest rates, has come up with the minimum lending rate policy

Banking: After the government asked the Royal Monetary Authority (RMA) to review interest rates, the central bank has replaced the base rate policy with the minimum lending rate policy, which will be effectively applied from next month.

It is however too early to deduce if interest rates will fall or not because the methodology of determining the final lending rate is left to the banks.

It is again designed in such way that if the banks charge too high rates, the repercussion would manifest in the form of trailing behind the competition within the financial sector.

The RMA will, however caution the banks to go slow on loans towards sectors that drive consumption while providing attractive interest rates towards sectors that drive economic growth and generate employment.

This means that banks are encouraged to charge higher rates than their average lending rate on “unproductive sectors” and the margin be used to endow loans availed for the “productive sector.”

The RMA governor, Dasho Penjore said the new policy will set a single benchmark minimum reference rate for lending across all banks and non-banking financial institutions.

The earlier base rate policy, Dasho Penjore said, was the right policy implemented at the right time as the country was draining huge rupee reserve on imports. “But the relevance of the policy changed with time. It was not a wrong policy,” he said.

Minimum lending rate computation

Minimum lending rate (MLR) = Marginal cost of fund + negative carry charges on CRR + operating cost – A single MLR is computed by averaging the MLR of individual banks.

– The MLR will be used uniformly by all banks and non-banking financial institutions.

– Based on the existing cost factor of five banks, the MLR is computed at 7.25 percent.

– Unlike the base rate for each bank, MLR will be the common benchmark or reference lending rate for all banks.

– On the common MLR, each bank will competitively add its expected spread or expected profit margin to arrive at Final lending rate.

– The main objective of MLR is to encourage competition and professionalism among the banks to result in balanced approach of engaging in financial intermediation between lenders and depositors.

In 2012 when the RMA introduced the base rate system, he said the country was experiencing 33 percent credit growth that turned into a major imbalance in the country’s current account, swelling inflation and causing an upsurge in the prices of fixed assets.

Currently the growth in credit is recorded at 15 percent. “So there is some room for growth,” he said. But to ease the pressure on the reserve and current account, an official from the RMA said banks must provide favourable lending rates towards productive sectors and contain the credit to the unproductive sectors that lead to consumption.

Even the Reserve Bank of India (RBI) has implemented the same policy starting April 1.

He said that the new policy would ensure best returns for savers (depositors) and best costs for lenders (banks). Consultations were held with the financial institutions, government and experts from the RBI. “It is not RMA’s policy but a national policy because interest rates affect everyone,” said the governor.

Before coming up with the new policy, the existing base rate policy was reviewed and problems were identified.

Earlier, banks have been assuming that should the lending rates fall, the deposit rate might fall as well. “Henceforth banks that can offer more deposit rates will get more deposits,” the governor said, adding this was to encourage a saving culture.

However, the impact of the policy is not expected to bear fruit immediately because the financial institutions are expected to bring about gradual reforms starting August 1. The central bank will, however review the policy with data from banks every six months.

The new approach

There are three parameters to determine the minimum lending rate-marginal cost of fund, negative carry charges on cash reserve ratio (CRR) and operating cost.

To deduce the marginal cost of fund, each bank will assign weights to each type of deposits such as recurring, fixed and corporate deposits. The weights would then be multiplied by respective interest rates. The average would then yield the cost of mobilising the bank’s deposits.

For every deposit, the banks must set aside 10 percent of its total deposit as CRR. An official from the RMA explained that this is a cost for the banks, which is not computed in the earlier system. This would now be remunerated.

The operating cost of the banks divided by the total deposit would yield unit cost of operation for every deposit.

Adding these parameters, individual banks come up with a minimum lending rate and the average of which is considered the national minimum lending rate.  Based on the figures from the existing five banks, the minimum lending rate is derived at 7.25 percent. This means that it is not viable for any bank to lend below this rate.

However, the final lending rate the banks charge to its clients takes into consideration the credit risk premium, which depends on credit worthiness of the banks, tenor risk and businesses’ strategies. These factors determine the profit margin of the banks.

This would promote competition within the financial sector. The governor explained that there is no room for the banks to make mistakes in the calculations. Although the average lending rates might not go below 10 percent, the governor hinted that loan for the productive sector might go below the average lending rate.

For instance, the average final lending rate of a bank may be 12 percent. The bank can charge about 14 percent in some sectors and provide nine percent interest loans to some sectors. The banks, he said can compete by playing with this margin. In the earlier system every loan product had its own fixed lending rate and every bank had a different base rate.

The determination of marginal cost of fund has also helped the banks to overcome the notion that corporate deposit were profitable. Calculations revealed that corporate deposits had the highest cost of mobilization and is actually an expensive affair for a bank. Until now, the RMA official said banks preferred corporate deposits over retail since it was easily available.

With the new system the game might change gradually as competition kicks in.

The new approach, according to the RMA, ensures a stronger link between the final lending rate and expected profit of the bank, while providing a framework for each bank to competitively and continuously assess its costs and opportunities.

The policy is also integrated with other monetary aspects as it promotes investment through interest rate policy reform, provides a direction on domestic credit and strengthens the capacity of financial institutions.

A circular to the banks on the adoption of new policy would be issued today.

Tshering Dorji