TSM Business Review

Abstract

Different financial instruments have different risk - return profiles. Investors are risk averse and higher risks warrant higher rates of return.

Issue of debt securities via public and rights issues requires mandatory rating. Securities issued in domestic and global markets are rated by diverse rating agencies. Domestic CRAs set the sovereign risk associated with the country of origin at zero, while global rating agencies account for sovereign risk as well.

CAPM expresses return from a security as the sum of risk free rate and risk premium, which is proportional to risk. For securities denominated in domestic currency, it has been customary so far to consider gilt edged securities as risk free. However, recent economic turmoil in various economies has necessitated a re-look at this practice. A reformulation of CAPM incorporating impact of sovereign risk seems called for and it may be appropriate to introduce a fresh benchmark rate for this purpose.

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Abstract

RBI was facing a good deal of criticism because commercial bank’s lending rates were not decreasing as fast as some groups expected it to come down. With a view to overcoming such criticism, RBI wanted the efficiency of monetary policy transmissionto improve andprescribed a formula whereby commercial banks could work out a Marginal Cost of Funds based Lending Rate(MCLR).

We undertake a critical evaluation of the two equations used by RBI for this purpose and find that there is some lack of overall compatibility in the entire process. We re-formulate these equations to accommodate the requisite internal consistency and re-work the Marginal Cost of Funds based Lending Rate. The current scenario for NPAs and possible irrecoverable loan assets of commercial banks is also discussed and its possible impact on MCLR is dwelt on.

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