How Are Repo Rate Cuts By RBI Transmitted In Bank Interest Rates?

Various economists and analysts have predicted another repo rate cut by the Reserve Bank of India (RBI) at its upcoming monetary policy meet scheduled for 6 June.

It is a common belief that since the repo rate is the rate at which the central bank lends to all the commercial banks, it should mean that interest rates on retail loans and deposits made will also come down. It is also been often said that the reflection of this repo rate change in the bank interest rates is not very quick as expected. However, the calculation of the interest rates at which a bank borrows or lends is not that simple and repo rate is not the only factor that is considered.

How are interest rates calculated?

Firstly, one needs to understand that banks are businesses, and they intend to make a profit from the interest income (which is the difference between how much they pay on the deposits and what they receive as interest on loans).

Even if say interest rates on fixed deposits are changed, the interest already promised on past fixed deposits have to be paid as guaranteed. Additionally, lower interest rates also means lower chances of increase in the number of customers that would be interested in making deposits.

The increased burden of provisions for NPAs, in the recent past should also be accounted for.

This means that there are many revenue metrics that are included in the calculation of base rate and MCLR (which are the minimum interest rates below which a bank will not lend). In order to calculate the MCLR, on which most long term retail loans are based, repo rate is just one of the factors and not the only factor.

How important is repo rate?

LAF or Liquidity Adjustment Facility is the tool that RBI uses to allow banks to borrow money through repurchase agreement (repo) in times of short-term cash shortages.

The rate at which this amount is borrowed forms a negligible part of the bank's total cost of funds (these are fixed at 1 percent of Net Demand and Time Liabilities) as these are usually reserved to be used to meet shortages in cash due to unforeseen circumstances (like recession).

It is therefore, the deposit cost changes that becomes one of the larger factors in deciding the extent of change in MCLR.

Individual factors

The State Bank of India (SBI) decided to link savings deposit rates and short term loans to the repo rate as a benchmark starting 1 May, the first among Indian banks to do so. However, it did not do that with term deposits or long term loans because hold greater risk for the bank considering the large amount involved.

Further, every time SBI changes its interest rate will not mean that other banks will follow. Each bank has its own calculation metrics to follow to stay profitable.

Similarly, a fall in interest rate will not mean you will get a cheaper loan as the rate at which the bank will allow you to borrow will depend on the size of the loan and your credit score. Loans are given after the bank assesses the individual's or the entity's risk profile.

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