On 27 March 2020, the Reserve Bank of India (RBI) reduced the repo rate by 75 basis points (bps). The reduction saw the repo rate reduce from 5.15% to 4.40%. Last year, on 7 February 2019, the repo rate was reduced by 25 basis points to 6.25%. RBI reduced it again on 4 April 2019 to 6.00%. On 6 June 2019, the repo rate was reduced to 5.75% after the central bank slashed it by another 25 basis points. The repo rate was reduced by 35 basis points on 7 August to 5.40% and again by 25 basis points on 4 October to 5.15%.
RBI had also reduced the reverse repo rate by 90 bps on 27 March and stood at 4.00%. It was slashed by another 25 basis points on 17 April and now stands at 3.75%. The fresh reduction in the rates was taken by the central bank due to the coronavirus pandemic, which has hurt the global economy. The marginal standing facility rate and the bank rate stand at 4.65% respectively.
Note - One basis point or bps equals to one-hundredth of a percentage.
Repo rate, the bank, and the customer
Repo rate is the interest at which RBI lends money to commercial banks in the country. Every time this rate reduces, it means that other banks can now borrow money from RBI at a much lower interest rate.
The commercial banks usually pass this benefit on to their customers by reducing the interest rates on the loans they offer. Therefore, every time there is a cut in the repo rate, there usually is a decline in the interest rates on loans offered by various banks.
How does this help you? It reduces your interest rates which means you pay a lesser amount of interest. This brings down the overall cost of your loan.
Personal loans, car loans, home loans, etc. are expected to get cheaper due to the recent reduction in the repo rate. However, this will come into effect only if banks decide to pass on the benefit to their customers.
How it impacts the industrial sector
Apart from benefitting general borrowers, this also is a huge boost to the industrial sector. The reduction in the repo rate means that industries may be able to get loans at cheaper interest rates from lenders. This is likely to result in commodities becoming cheaper due to lower interest costs, ultimately benefitting you, the end consumer, again.
That said, it remains to been seen how soon banks will implement rate cuts on the loans they offer.
Pass through of policy rate cuts
When a reduction in policy rates occurs, financial circles are usually buzzing with questions on when the rate cut will translate into actual reductions in bank loan interest rates.
The International Monetary Fund (IMF) conducted a study on the interest rate transmission in the country, in which, the following were deduced:
- There is a slow pass-through of policy rate changes to the interest rates offered by banks.
- Banks tend to decrease the deposit rates during rate cuts but do not reduce lending rates right away. However, when the policy rate increases, lending rates rise quickly, but deposit rates don’t change that fast.
What Makes The Monetary Transmission Slow?
Money is a bank’s raw material, absolutely vital to its day-to-day operations. In any industry, whenever an important supplier reduces the prices of the raw materials it supplies, it triggers price cuts downstream. This refers to deposit rates in the case of banks.?
Now, whether a bank passes on the benefit of the lower interest rate to its customers or not depends on the level of competition in the market.
If any particular bank holds the monopoly power in the industry, it is not under any pressure to pass on the lower-cost benefits to its consumers right away. This means that the transmission of benefits arising out of RNI rate cuts may end up taking a long time.
Let’s take a look at some of the reasons for this:
- Banks also find it difficult to reduce lending rates in the short term after a policy rate cut due to the fixed rate of interest on deposit contracts. Also, there is competition from small savings instruments, which makes it difficult to reduce the rates that depositors are offered.
- Another issue that impedes monetary transmission is the pressure on banks to enhance equity financing and reduce risky debt financing. This problem is particularly relevant to the current financial landscape in India.
- The new focus stems from the financial crisis in the U.S. that drew attention to the dangers of debt financing and excessive dependence on it. At the time of a policy rate cut, reducing the deposit rates (and not the loan rates) is a convenient way for banks to increase their interest margins. This also paves way for increased profits, which are in fact, a form of equity that improves their balance sheets.
- The level of equity needed by banks is determined by the amount of loans they have. When they don’t immediately cut loan rates, banks stand a chance to lose some customers. The current financial environment accepts that loss because it retards the growth of loans and the subsequent need to improve equity.
- Therefore, the speed at which rate cuts pass through will be slow if the banks are facing pressure from regulators to improve their capital buffer.
- The government ownership of banks also acts as an impediment to transmission. The ability of a government bank to increase equity depends on its disinvestment programme and the decision to infuse equity. Since banks do not control this decision, they increase the interest margin and slow loan growth. Hence, the monetary transmission, in this case, is dependent on the government’s decision to shore up the balance sheets of banks.
- Some commercial banks have indicated that a CRR cut is required to bring about a traction in monetary transmission. A meaningful cut in CRR, apart from introducing additional liquidity into the system, frees resources to lend and helps banks in passing on rate cuts without adversely impacting their net interest margin.
While this is a great tool to control inflation, RBI often uses this monetary policy method after factoring the condition of the Indian economy and inflation levels to control the market inflation and manage the liquidity of the economy. However, this process might not prove to be effective if the banks are not ready to pass on the rate cut to the customers.
The bottom line is that apart from the lag in monetary transmission, banks are unlikely to match RBI’s rate cuts. However, additional rate cuts and liquidity support measures are needed to encourage banks to lower rates in the future.