The Reserve Bank of India on 1 August 2018 increased the repo rate by 25 basis points (bps), increasing the rate from 6.25% to 6.50%. The decision is taken by the central bank in the third bi-monthly policy review for the financial year 2018-19. In this respect, the reverse repo rate has also seen a rise, it has raised up from 6.00% to 6.25% with an increase of 0.25%. Because of this hike in the lending rates, the Marginal Standing Facility (MSF) Rate now stands at 6.75% which was 6.50% previously. This is the second time in the past two months that RBI has increased its key rate of lending to the banks. Earlier, a hike in the repo rate was announced in the second bi-monthly policy review of RBI for the year 2018-19. This time RBI has decided to increase its rates of lending to the banks with an intent to combat the uprising inflation concerns in the country’s economy.
Note - One basis point or bps equals to one-hundredth of a percentage.
Repo rate is the interest at which RBI lends money to other commercial banks in exchange for government securities. After a rate cut, the commercial banks can withdraw money from the central bank at a lower interest rate. Therefore, the interest rates on loans are likely to decline to post a cut in the repo rate. Besides the industrial sector, the biggest beneficiaries of a repo rate cut are the general borrowers. Home loans, personal loans, and auto loans are set to get cheaper for the public at large, as the lenders prepare to transfer the benefits to their customers. Many banks have already started announcing cuts in MCLR, leading to greater benefits for loan seekers.
Pass through of policy rate cuts
When a reduction in policy rates occur, the conversations dominating the financial circles would be regarding the transmission of this rate cut to the borrowing capacities of firms and consumers. In a study conducted by the International Monetary Fund on the interest rate transmission in the country, the following was deduced:
- There is a slow pass-through of policy changes to interest rates offered by banks.
- Banks are seen to decrease deposit rates during rate cuts but do not easily reduce lending rates. However, in the case of rate increases, lending rates rise quickly, but deposit rates lag behind.
- The transmission to the deposit rate is larger than that of the lending rate. Moreover, the deposit rate calibrates quickly to alteration in policy rates.
- The RBI governor has been encouraging banks to cut interest rates subsequent to policy rate cuts. However, the reasons for the slow monetary transmission are multiple, specific to the country and otherwise.
What makes the monetary transmission slow?
Money is considered as a bank’s raw material. When RBI cuts rates, the situation echoes the fall in the price of raw materials from an important supplier. This reduction in supplier price triggers price cuts downstream, i.e., deposit rates in the case of banks.
Whether a company passes on lower prices to its customers or not depends on the existing competition in the market. If the company holds monopoly power in the industry, they are not under any pressure to pass on the lower costs to consumers. The case of Indian banks is much the same.
- Small borrowers and families do not have many choices for alternative sources of finance; hence banks enjoy a monopoly over them. This is one reason for policy rate cuts not penetrating to the small borrowers instantly. This is, however, true for most developing countries, and not for India alone.
- 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.