Answer:

Generally, the effect of a policy rate change would be passed on to a large share of the population. But in India, when the RBI changes the policy rate, the impact is felt by only a small fraction of the population and it has not led to any major changes in interest rates charged by the banks.

The changes in policy rate would affect the entire economy through banking system, bond market and exchange rate system. But in India, none of these channels are working effectively in monetary policy transmission.

♤ First, Indian economy is dominated by public sector banks and the private banks and foreign banks face lot of entry barriers. Therefore, the small number of banks thwarts competition among the existing banking system, which does not feel the necessity to pass on the policy rate changes to the final consumers.

♤ Second, in India we do not have fully developed bond market, as it is in advanced economies. In the absence of large and liquid bond market, the burden of monetary policy transmission falls on the banking system.

♤ Third, in an open economy with flexible exchange rate and monetary independence, the policy rate changes have impact on capital flows and exchange rate. But in India, the capital market is burdened with several restrictions; therefore the change in policy rate does not necessarily result in concomitant changes in capital flows.

♤ High CRR and SLR-Cutting down on statutory liquidity ratio (SLR) currently pegged at 21.5% will theoretically allow banks to use more money to give loans to borrowers instead of investing in government bonds. Similarly, banks’ cash reserve ratio (CRR), or the deposits that commercial banks are required to keep with RBI (on which they do not earn any interest), can also be cut.

The marginal cost-based lending rate (MCLR) refers to an internal benchmark rate for the bank below which bank cannot lend, except in some cases allowed by the RBI. It describes the method by which the minimum interest rate for loans is determined by a bank - on the basis of marginal cost or the additional cost. This new methodology replaces the base rate system. Under the base rate system, the repo rate is not included to determine the base interest rate; however, under the marginal cost-based lending rate system, it is mandatory for banks to consider the repo rate while calculating the marginal cost-based lending rate. This improves the transmission of policy rates into the lending rates of banks.

Other benefits of MCLR include:

♤ Brings transparency in the methodology followed by banks for determining interest rates on advances.

♤ Ensures availability of bank credit at interest rates which are fair to borrowers as well as banks.

♤ Enable banks to become more competitive and enhance their long run value and contribution to economic growth.

However, certain loans like fixed rate loans of tenor above three years, special loan schemes formulated by Government of India, Advances to banks’ depositors against their own deposits, Advances to banks’ own employees etc. are not linked to MCLR.