It, however, needs to be stressed once again that prime lending rates of banks for commercial credit are entirely within the purview of the banks and are no longer set by the Reserve Bank. Decisions in regard to interest rates, therefore, have to be taken by banks themselves in the light of various factors, including their own cost of funds, their transaction costs, and interest rates ruling in the non-banking sector, etc. While greater flexibility in interest rates is a most desirable objective, it has to be recognised that banks face several structural and other constraints. The non-interest operating expenses work out to 2.5 to 3.0 per cent of total assets, putting pressure on the required spread over cost of funds leading to high lending rates. Relatively high overhang of NPAs together with interest tax pushes further the lending rates.
Banks do have the freedom to offer variable interest rates on longer term deposits.
However, the preference of depositors for as well as the traditional practice with banks is to offer fixed interest rates on term deposits. The effect of this practice is to reduce the flexibility that banks have in lowering their lending rates since the rates on the existing stock of deposits cannot be lowered. There is persistent and large volume of market borrowing requirements by the Government giving an upward bias to the entire interest rate structure. Interest rates on contractual savings like Provident Fund, National Savings Scheme are substantially higher than long-term deposit rates of banks. Similarly, private sector mutual funds offer a much higher rate of interest than those offered by banks on their term deposits.