RBI Interest Rates & its Evolution over 20 Years (2000-2019)

RBI Interest rates and its methodology has been evolving in India. And for good measure knowing the importance of interest rates in consumer spending, inflation, bond markets, stock markets, lending, consumption and capital expenditure. In this post, we track the history of interest rates in India over the last two decades.

Interest Rates in India

The chart above shows the meandering path taken by the India’s policy rate over the last two decades.

In September 2008, the interest rates were on a high of 9.00%. Why? Because 2008 was a time of boom with asset bubbles forming and inflation creeping up.

By February 2010, the interest rates had come crashing down to 4.75%. This was the time when the 2008-2010 financial storm was depressing consumption, inflation and unemployment was on the rise..

The historical interest rates of the RBI are available in the table below.

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Inflation and Interest Rates in India

The key determinant in fixing policy rates is inflation.

Is that really the case?

I have plotted the inflation rates against the policy interest rates to understand the correlation between the two indicators.

Hmm.. so what do we learn from this?

The chart above reveals a close correlation between interest rates and inflation. This is in line with the central bank’s objective of keeping inflation in check by adjusting the interest rate. And this way, the RBI can regulate the flow of credit, capital investment and consumption.

We see that in two periods (2003-2008 and 2014-2019), the RBI responded to the heating up of the economy. RBI responded by increasing the repo rate when they saw inflation inflation steadily increasing from 2003 to 2008. In contrast, the RBI decreased the repo rate to spruce economic development in a low-inflation period of 2014-2019.

The only exception to this was the period between 2009 to 2011. The RBI moved in and dramatically reduce the repo rate to encourage more investments and job creation in India. This was the period when the world was going through an economic crisis. This crisis was of epic proportions due to the meltdown of the financial and banking system in the United States and the world.

In the next few sections, we shall be looking at the evolution of the RBI interest rates regime in India. We’ll be looking at why they were introduced, what they helped with, their pros and their cons.

What is Prime Lending Rate (PLR)?

The Prime Lending Rate (PLR) was introduced in 1994. The PLR regime owes its origin to the recommendations of the Narshimhan committee on the banking sector.

The report gathered consensus that lending rates should be free from any regulations. In other words, based on availability of funds and operational expenses, banks should be given the freedom to decide their lending rates.

OK, fair enough. So what’s so wrong about this?

Weaknesses with Lending Rate or PLR

1. Allowing banks to fix their own PLR meant the rate varied widely across banks.
2. The individual bank PLR was generally not in line with overall direction of interest rates of the Indian economy. This meant the Central Bank’s core monetary policy objectives were far from achieved
3. The PLR is the rate quoted by banks to its best rated customer (also called their Category A customers). Category A customers were borrowers who had a very high ability and very high intention to pay. As a result, these borrowers received undue advantage of the system’s flexibility and obtained short-period loans at minimal interest rate. This was counter-productive in the end as banks were forced to quote competitive rates to retain customers. And more competitive the rate, higher was the threat to the profitability of the banks.

In light of these issues, the RBI introduced the Benchmark Prime Lending Rate (BPLR) in place of PLR.

What is Benchmark Prime Lending Rate (BPLR)?

The Benchmark Prime Lending Rate (BPLR) was introduced in 2003. The BPLR’s focus was on transparency and to ensure that loans were appropriately pricing.

The Benchmark Prime Lending Rate was based on the concept of affordability of credit. The calculation of the BPLR was aided by an understanding of four variables –

1. Average cost of deposits
2. Operating expenses
3. Probable loan losses
4. Profit margin

The interest rate is considered as cost of credit.

The BPLR was certainly better than the PLR and was based on the rate at which credit was flowing into the system.

Deficiencies in the BPLR methodology

While the BPLR brought more transparency, this was also the time where new sources of funding were being developed. These included ECB (external commercial borrowings), FCCB (Foreign Currency Convertible Bond), ADR (American Depositary Receipt) and the GDR (Global Depositary Receipt).

These new sources of credit had reduced the dependency of institutions (corporates) on banks for finances. Consequently, the borrower’s bargaining power had been hugely enhanced.

2003 was also the time when private banks had started to get more aggressive in taking deposits and giving credit. There was HDFC Bank, Axis Bank, ICICI Bank, Yes Bank and IndusInd Bank who were serious competitors.

Increased competition were forcing banks to lend at a rate lower than the quoted rate of the interest BPLR. This reflected poorly on the Reserve Bank of India and the country’s monetary transmission. This forced the RBI to introduce a new system of lending – the base rate system of lending.

What is Base Rate?

The Base Rate system was introduced in the year 2010 as a replacement to the BPLR and PLR. The base rate is the minimum rate set by the Reserve Bank of India below which no bank in India can lend to its customers.

Like it’s predecessors, the base rate system was introduced to promote transparency in lending activities. The base rate also sought to ensure that banks pass on advantages of lower cost of funds to their customers.

The base rate methodology allowed for each bank to freely determine its own base rate based on certain criteria prescribed by the RBI.

Consequently, the base rate of banks differed from each other on account of the RBI variables of calculation. As a thumb-rule, the difference was largely on account of the rate at which deposits were offered by the banks.

The RBI variables for base rate calculation were as follows –

• Average Cost of Funds i.e. the interest rate on deposits
• Operating costs i.e. day-to-day running expenses
• Negative carry in Cash Reserve Ratio i.e. the cost of the amount that banks needed to keep as cash reserves with the RBI
• Margin of Profit (or Return on Net Worth) i.e. the percentage profits and the absolute amount of profit

Shortcomings of the Base Rate methodology

1. The most prominent shortcoming was the reluctance of banks to pass benefits of interest rate reduction to its customers. For instance, the RBI interest rates are cut by 125 bps (bps stands for basis points; 100 bps = 1%) however the banks lower interest rates by 30 to 40 bps only. Clearly, the borrowers were not getting any advantage of the rate cut.
2. By not passing rate cuts to consumers, the banks were rendering the RBI’s monetary policy moves totally redundant. With on-ground interest rates not changing much, the RBI’s management of macro issues like growth and inflation were remaining stuck. The bank’s myopic thinking was not matching through.

When questioned by the RBI, the banks response of not following the RBI mandate (or deferring execution) was pinned on the bank’s methodology. Afterall, banks were following an average cost of fund methodology which is a function of the cost of deposit.

Let’s understand this with an example.

Average Cost of Funds methodology followed by banks

Thousands of users have invested their money with a reputable bank at 10% interest rate. This is the fixed interest rate that this bank is bound to pay under any circumstance.

Now, assured of a 10% outgo in the form of interest, banks have to charge a number higher than 10% from borrowers. Hence, this bank charges borrowers a 13% rate of interest which gives the banks a 3% net interest margin. We are ignoring provisions and defaults in this example.

We take a scenario where the RBI suddenly reduce the interest rates by 150 bps i.e. 1.5%. If the bank were forced to drop their lending rate by 1.5% overnight, then the bank will have to consider a new scenario. This scenario is where the bank will have to convert a large chunk of all existing loans into this lower interest rate. Because, if they don’t do so, consumers will simply transfer their balance to a different bank. Or they will foreclose this expensive 13% interest rate loan if credit is available at a lower rate elsewhere.

To improve the process of rate setting and rate acceptance, the MCLR system was introduced in April 2016

What is MCLR?

Currently, the RBI requires all commercial banks to use the Marginal Cost-of-funds-based Lending Rate (MCLR) methodology to set their interest rates. This system replaced the previous “base rate” system from from April 1, 2016.

Difference between Base Rate and MCLR

Methodology of calculating Interest rates

Under the base rate system, the pricing of loans depended on a spread over the base rate. So, if the base rate was 8.00% and spread was 75 bps, then the interest rate on the loan was 8.75% (i.e. 8.00% + 0.75%).

However, under the MCLR system, the interest rate works out differently.

Let’s draw an illustration for better understanding.

You took out a loan on 1st February 2018 at a one-year MCLR of 8.00%. Since the spread is 75 bps, you will be charged an interest rate of 8.75% on a one year loan. This interest will be valid until 31st January 2019 post which the rate will reset automatically at the prevailing MCLR+spread rate.

The MCLR will be reviewed and can be changed every month. For a consumer, this is a world of “variable interest rates” unlike the base rate methodology. These revisions are required to ensure that lenders pass on any rate cuts to the consumers and vice-versa.

Variables used in the calculation of the interest rates

The base rate uses the following four variables –

• Cost of funds
• Operating expenses
• Profit margin
• Cost of maintaining the CRR (Cash Reserve Ratio)

Other the other hand, the MCLR uses the these four variables –

• Marginal cost of funds*
• Operating expenses
• Tenure premium **
• Cost of maintaining the CRR

* Marginal Cost of Funds is the most important component of the MCLR which holds 92% influence on the rate. The other variables have only an 8% influence. The Marginal Cost of Funds comprises of the marginal cost of borrowings along with return on net worth. It also depends on the repo rate which is a big factor in the calculation of the marginal cost of funds. Note: repo rate was not incorporated in the base rate system.

** The Tenor Premium is the premium or additional rate that will be charged for long-term loans. This is done to mitigate the risks associated with long-term lending which is fraught with much more risks than short term lending. The risks include defaults, missed instalments, refinancing at lower rates, change in interest rates etc.

What is repo rate?

Repo or Repurchase rate is the benchmark interest rate or the rate at which the Reserve Bank of India (RBI) lends money to commercial banks for a short-term i.e. a maximum of 90 days.

When the repo rate increases, borrowing money from the RBI becomes more expensive. This means the banks cannot carry out their business at a profit as the margins (or spreads) reduce. This in turn means that less loans are sanctioned to borrowers. And this leads to a general reduction in economic activity and consumption.

The RBI uses repo rate increases when it sees signs of inflation and wants the country’s economy to cool down.

On the other hand, the RBI reduces the repo rate if the central bank wants banks to borrow more and offer more loans to businesses and consumers. Generally, repo rates are reduced when the RBI needs the wheels of the country’s economy to churn faster.

Allright. I got that. So how does this repo work?

If banks want to borrow money (usually overnight) from RBI, the banks have to pledge government securities as collateral. This happens happens through a re-purchase agreement. For example, if a bank wants to borrow ₹100 crores –

1. It has to put forward government securities worth ₹100 crores
2. Agree to repurchase them at say, ₹102 crore at the end of borrowing period

Net net, the bank has paid ₹2 crore as interest. This is the reason it is called repo rate.

Banks and MCLR

Banks publish the internal benchmark (MCLR) every month. MCLR is declared for –

• Overnight
• 1 month
• 3 months
• 6 months
• 1 year
• 2 years and
• 3 years maturities

At the time of writing this article, the State Bank of India offered the following MCLR rates for different maturities.

• Overnight : 7.60%
• 1 month : 7.60%
• 3 months : 7.65%
• 6 months : 7.80%
• 1 year : 7.85%
• 2 years : 8.05%
• 3 years : 8.15%

These rates were issued on 10 February 2020. Current MCLR rates from SBI.

I mapped out the MCLR offered by the State Bank of India over the last 24 months across different maturities. See below.

The MCLR has vacillated from a high of 9.20% (Apr 2016) to a low of 7.95% (Nov 2017 to Feb 2018) for the 1-Year maturity. Further, there have been periods of stagnation where the rates remained still between Jan 2017 to Oct 2017 across maturities.

There was one mighty fall in the MCLR. This was when SBI announced a bonus of sorts for borrowers when it reduced it’s MCLR by an eye-popping 90 basis points (0.90%). This is among the steepest rate cuts ever and was aimed at boosting the loan growth which had fallen to a multi-decade low.

This was done at the peak of the demonetization exercise when banks were flush with funds. It also didn’t help that businesses were not keen to borrow for any capital expansion activities. Consumers too were less interested to borrow given the confusing situation the country was in with re the economic growth.

Advantages of MCLR

The MCLR was introduced by the RBI because interest rates based on the MCLR system are more receptive to the changes in the policy rates. More importantly, this system also ensures that the country’s monetary policy is implemented across all spheres.

The introduction of the MCLR has certainly made things simpler, transparent and convenient for borrowers. The system has also infused some competition amongst banks leading to competitive interest rate on loans. This helps businesses and consumers keeping the economic engine running.

Issues with MCLR

In 2015, the RBI cut rates multiple times in 2015. Infact, over an year, the repo rate was slashed by 125 basis points (1.25%). The issue was that banks reduced lending rates by only 60-70 basis points during that period. And this prompted the RBI to introduce the MCLR system.

The aim of MCLR was to have speedy and equivalent transmission of rates in response to changes made in the repo rate by the RBI. However, things didn’t move in the intended direction with the MCLR.

From a repo rate of 8% in January 2015, there has been visible reduction with the repo rate at 6% in April 2019. That’s a 200 bps reduction in repo rate. However, we see that home loan interest rates from State Bank of India (SBI) reduced by only 140 bps. SBI home loans was available at 10.15% in January 2015 and is now at 8.75% in April 2019. Ideally the home loan rate should have come down to 8.15% in line with the reduction in the repo rate. But the banks didn’t do that which is the primary issue with MCLR.

MCLR of Banks in India

Here’s a list of the MCLR for popular banks in India per a list released by the RBI

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Proposed new benchmark for determining lending rates

The RBI has plans to replace the MCLR with an external benchmark for fixing interest rates on retail loans by banks. This is expected to increase transparency and speed of transmission of changes in interest rates from banks to consumers.

The MCLR’s biggest problem is the lag in the transmission of policy rates to the borrowers. It currently takes upto six months for banks to transfer the new MCLR rate to its borrowers. When the RBI cuts repo rate there is no guarantee that the borrower will receive the benefit of the rate cut. This is due to the internal benchmarking of loan pricing which means policy rate cuts often don’t reach the end borrower.

Here is a brief timeline of India’s evolving lending rate program

The RBI has given four options to the banks with regards to this external benchmark. The bank can choose –

1. RBI repo rate or,
2. 91-day T-bill yield or,
3. 182-day T-bill yield or,
4. Any other benchmark market interest rate produced by the Financial Benchmarks India Pvt. Ltd.

Banks will have to use one of the above benchmarks to decide on the lending rate in addition to the spread.

While the banks will be free to decide their spread value, the spread has to be fixed for the tenure of the loan. However, the bank can change the spread if the credit score of the the borrower changes. The interest rates under the new system will change every month. The proposed structure does not allow the same bank to adopt multiple benchmarks within a loan category.

Advantages of proposed new system

The benefit of the proposed system is better and faster transmission of policy rate cuts or increases. So when the RBI changes the policy rate, the same shall immediately (within the month) reach the borrower.

Additionally, the proposed system will improve transparency as borrowers will be aware of the fixed interest rate and the spread value decided by the bank. This will help borrowers compare loans from different banks better and take better financial decisions.

Banks tend to manipulate the system is on who-receives-what-rate. It is generally observed that the new borrowers tend to receive the new & attractive rates while old borrowers are the last to get the benefit of a rate cut. This is because most old borrowers are unaware of changes unless their EMI (equated monthly instalment) changes. However, with external benchmarks, the borrower need not wait for the bank to inform about the change in interest rate. This monitoring can be done by the borrower itself and banks cannot manipulate the spread unless there is a significant change in the borrower’s credit assessment.

The State Bank of India has taken some proactive steps in this direction. SBI has already linked the interest rates on savings account deposits above ₹1,00,000 with the repo rate. They have done the same with short-term credit of 1 year tenor such as overdraft and cash credit.

The RBI is yet to release the external benchmark system, But from what we see, it seems to have taken care of the issues related to the MCLR. It will certainly be a very welcome move for the borrower community at large.

Additional Resources

Here are some articles you can read to get better details on financial and stock metrics

• Rakesh Jhunjhunwala and his secrets to investing (Part 1)
• Building a high return portfolio with index funds – a step-by-step approach
• Complete SIP Investment Guide (over 8000 words compedium updated until 2020)
• The trillion dollar index fund story that John Bogle started in the 1970s
• Best SIP for achieving long term goals