EXTERNAL BENCHMARK FOR FLOATING

The amended Reserve Bank of India Act, 2016 has mandated the RBI to conduct monetary policy for achieving price stability as its primary objective while being mindful of growth. This mandated objective is difficult to achieve unless supported by a robust transmission mechanism (Acharya, 2017).

- B P Sharma

If lending rates of banks do not rise in response to rise in the policy repo rate by the MPC, consumption, and investment by households and firms will continue to rise and credit demand of firms and households will continue to grow. As a result, the corresponding aggregate demand conditions in the economy would not allow inflation to drop. Conversely, in an easing cycle of monetary policy, if lower policy repo rate is not followed by reduction in bank lending rates, consumption and investment demand will not pick up to help bring the growth back to the steady-state.

For more than 20 years after the RBI deregulated banks' lending rates, the absence of smooth transmission has remained a matter of concern. The first regime of Prime Lending Rate (PLR) was introduced in 1994. However, both the PLR and the spread were seen to vary widely across banks and bank-groups. Moreover, PLR continued to be rigid and inflexible in relation to the overall direction of interest rates in the economy.

With the aim of introducing transparency and ensuring appropriate pricing of loans, the PLR was converted into a reference benchmark rate and banks were advised in 2003 to introduce the Benchmark Prime Lending Rate (BPLR) system. While lending below the BPLR was expected to be at the margin, in practice about 77 per cent of banks' loan portfolio in March 2007 was at sub-BPLR2. In essence, both PLR and BPLR did not produce adequate monetary transmission to the real economy. This defeated the very purpose for which these benchmarks were introduced.