Interest Rate Management: An Interesting Conundrum

It is reported that Finance Minister, while reviewing the lackluster growth in the manufacturing sector with key industrialists from automobile industry and select bankers, asked the latter to find ways of lowering their cost of funds so as to bring down the lending rates. It is also reported that he desired bankers to ensure that interest rates did not constrict investment and growth in demand in the economy.

The next day, the press as usual highlighted the statement as a diktat to banks from the Finance Minister. As though to give credence to the press reports, the country’s largest and the second largest banks—State Bank of India and ICICI Bank—slashed down their interest rates on various loans. The State Bank of India lowered its interest rates on new house loans, car loans and truck loans by 50 basis points to 200 basis points. It also lowered its deposit rates under certain categories. ICICI Bank also cut its interest rates, of course, marginally by 25-50 basis points on home, car and personal loans. It however, did not tinker with its deposit rates.

Intriguingly, both these banks announced these reductions as a festive offer to the prospective borrowers. This only makes one wonder if these two banks are finding it difficult to take a firm view on the future direction of interest rates. This sentiment indeed finds its echo in what the Chairman of the State Bank of India said immediately after the Finance Minister asked for soft interest rates: “Deposits are important to us.... We cannot cut rates unilaterally, and be out of sync with the market.”

The immediate question that this episode raises is: Who has to and how to decide the lending rates of commercial banks? Commonsense dictates that fixing of lending rates being a commercial decision must be done by the banks themselves since they alone know the cost of their funds, earnings foregone by virtue of compliance with mandatory provisions under CRR and SLR, their operating costs, provisioning needs, cost of owned-capital, and the minimum percentage of profit required to be earned to satisfy the shareholders. It is thus ideal if the individual bank managements decide the lending rates.

With the launching of financial reforms, banks have been empowered to determine their interest rates, be it on loans or deposits, of course subject to certain exceptions. But the kind of statements made by the Finance Minister recently makes one wonder if banks are truly free to decide what is in their best interest. Some may even wonder if the present ‘diktat’ of Finance Minister can be called an interference from the government, for the government is the majority shareholder of the public sector banks. True, no one can deny the role of the majority shareholder in attempting to define the business model. But such an intervention may pose hiccups under corporate governance, for the Chairman and Board of banks have to pursue what is in the interest of all their stakeholders and the society at large. It is this conflict that merits due diligence from the majority shareholder—the government—and the bank managements.

That aside, the current episode poses a fundamental question: Who is accountable for monetary policy? The Reserve Bank of India, the monetary authority, has been steadily raising interest rates to moderate the current growth rate with an ultimate objective of reining in the inflationary pressures. The obvious rationale behind the move is: the current high growth rate is not sustainable, for there is a risk of it kicking off an inflationary spiral. If this act of the monetary authority has to achieve its intended objective, banking system has to respond to it with appropriate action, i.e., raising lending rates, not lowering them as asked by the Finance Minister, for banks are the conduits of the monetary policy. Else, the whole effort of the monetary authority would go topsy-turvy.

In view of the RBI’s current analysis of the economy, one is left wondering why there should be this conflict of interest between the two bodies meant for managing the economy. There is, of course, always an embedded risk in monetary policy implementation: the central banks may tend to over-correct a given macroeconomic fundamental, such as raising interest rates to a level higher than what is required to checkmate the inflationary pressure. This is more so because of the fact that the economy is always dynamic, never in equilibrium—at best, it may tend to be in a stationary state. Secondly, the independence of the RBI doesn’t mean a stony silence. Nor are the central banks and the Finance Minister, natural allies. Having said that, the Finance Minister has his own accountability. And, whenever a conflict in reading a macroeconomic fundamental arises, the best course for the government would be to have a dialog with the monetary authority in private and sort out the differences. In the modern practice of monetary economics, the Finance Minister is not required to publicly air his opinion, for interest rate management falls in the domain of the central bank. Secondly, and importantly, such public contradiction confuses market players in reading the monetary stance of the central bank, and to that extent their investment decisions get distorted. And this is certainly not in the interest of the overall economy and its growth.

Unfortunately, old habits die hard.

(November, 2007)