Who Benefits when the RBI cuts rates

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.
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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.

When RBI cuts rates

  • HDFC Bank may increase loan rates after the September 7 review

    ICICI Bank, one of the largest private banks in the country and State Bank of India recently raised raised the marginal cost of funds based lending rates effective September 1. It is expected that HDFC will be doing the same by revising the marginal cost of funds based lending rate when the bank takes it for review on September 7. State Bank of India increased its lending rate 0.20% across all tenors effective from September 1. It is expected that all the other banks will likely make changes to their marginal cost of funds based lending rates as well in the coming weeks. With the new changes, the marginal cost of funds based lending rates now ranges between 8.1 percent and 8.65 percent. The marginal cost of funds based lending rates of HDFC currently range between 8.40 percent and 8.70 percent.

    4 September 2018

  • Rs.136 crore Nabard warehouse fund sanctioned to Karnataka Government

    The Karnataka government has received a loan assistance of Rs.136.57 crore from the National Bank for Agriculture and Rural Developments(Nabard) as Warehouse Infrastructure Fund. The assistance from Nabard is to build 163 covered auction platforms at close to 135 Agricultural Produce Market Committees(APMCs) and 103 warehouses in 28 districts. Nabard has now sanctioned around Rs.1,271.62 crore under the Warehouse Infrastructure Fund for construction of 269 market yards and 340 warehouses across the 28 districts in the State.

    7 June 2018

  • India in the top spot among world’s fastest growing major economies

    According to a Reuters poll of economists, this year, India will likely be on the top spot amongst the world's fastest-growing economies. However, the increasing trade tensions between China and the US may put a strain on that growth. As per the latest poll, India's economy will grow 7.4% in this fiscal year. In the next fiscal, the economic growth is predicted to average 7.5%.

    Although the country's retail inflation has reduced this year, it was more than the RBI's 4% medium-term target. Government's increased spending before the national elections will likely be inflationary. Inflation is predicted to average 4.7% at the end of this fiscal year and 4.9% in the following year. India Met has forecast a normal monsoon in 2018 which is beneficial to the agricultural sector as it accounts for 15% of the country's $2 trillion economy. A normal monsoon may prompt a rate cut by the RBI in August.

    19 April 2018

  • RBI approves the acquisition of IL&FS Securities Services by Induslnd Bank

    The Reserve Bank of India (RBI) has given a nod to private sector banking firm Induslnd Bank to acquire the securities services division of Infrastructure Leasing and Financial Services (IL&FS). The size of the deal is, however, yet to be confirmed. The talks for this acquisition had been initiated in March 2017 and the proposed acquisition was of Indusind Bank having a 100% stake in IL&FS Securities Services Ltd. (ISSL).

    On the Bombay Stock Exchange (BSE), Induslnd Bank was trading at Rs.1796.30 exhibiting a low of 1.84%. Recently, Induslnd Bank had run tests for providing banking services to customers through Whatsapp and with the project, the private lender is looking at making communication with the customer two-way.

    9 April 2018

  • According to RBI, women’s share in banking rose to 19.3% in 2017

    According to the Reserve Bank of India (RBI), the percentage of women participating in banking rose to 19.3% in 2017 from 8.8% in 2001. About one-fifth of customers borrowing from banks were women and 32% of women had opened new accounts in 2017 compared to 22% in 2001. Even Small Finance Banks had had an increase in women customers due to their microfinance model, but this data was not included in the study conducted by the RBI.

    28 March 2018

  • RBI has revised reference rate for rupee at Rs.64.9941

    On 6 March, the Reserve Bank of India had announced the revised reference rate for rupee at Rs.64.9941 from Rs.65.0530. Likewise, RBI fixed the reference rate for Euro at Rs.80.2092 from Rs.80.0347. As for the British Pounds, the reference rate is at Rs.89.9063 from 6 March 2018 and Rs.61.20 for 100 yen (earlier it was Rs.61.64). The SDR-Rupee rate will be based on the new reference rate.

    14 March 2018

  • HDFC Bank hikes its MCLR by 10-15 bps

    On 7 March, HDFC Bank increased its marginal cost of funds-based lending rates by 10-15 bps which is the second raise in MCLR by the bank in a matter of a few months. The current 1-year MCLR is 8.3%. The overnight MCLR is 7.95%, 1-month MCLR is 7.95a5, 3-month MCLR is 8%, 6-month MCLR is 8.15%, and the 2-year MCLR is 8.45%, respectively. The 3-year MCLR of HDFC Bank loans was raised by 10 basis points to 8.6%.

    Punjab National Bank, ICICI Bank, and State Bank of India raised their MCLR earlier this month which is the first rate hike since the implementation of MCLR in April 2016. According to analysts, banks will have better pricing power as liquidity has tightened and large borrowers have transitioned to MCLR framework.

    9 March 2018

  • RBI scrutinises the process of allowing companies to raise money overseas

    The Reserve Bank of India (RBI) is scrutinising the hedging practices of companies and vetting borrowers carefully in order to be prepared for any fallout in the financial market owing to an increase in the US interest rates. The central bank is concerned about the borrowers' inability to repay debt in the case of any increase in rupee volatility. The approval process for offshore debt sales has slowed down in the recent weeks. Companies are required to get loan registration numbers (LRNs) for raising debt overseas as per the guidelines of the country's external commercial borrowing. RBI has been slow in issuing LRNs to some borrowers.

    After Indian companies raised $15.6 billion the previous month, the overseas bond sales have slowed down this month. Suzlon Energy Ltd, Indian Railway Finance Corp Ltd, Reliance Industries Ltd, Videsh Ltd, ONGC, and Bharti Airtel Ltd are some of the big borrowers who may be affected by any new restrictions on the offshore borrowing rules.

    21 February 2018

  • EPFO likely to raise the cap on investment in stocks by high-income employees

    The government set a minimum limit for equity investment to 5% for EPFO in April 2015. EPFO had an equity exposure of Rs.44,000 crore as of January 2018. The interest rate remains unchanged at 8.65%. Subscribers of the National Pension Scheme can invest up to 50% of their savings in equities. The Employees Provident Fund Organisation (EPFO) is proposing a similar investment limit to employees with higher salaries. The low-income employees will continue with the 15% cap while the high-income employees can invest 25% of their PF contribution in stocks.

    20 February 2018

  • Top banks regained hold in the banking space after RBI holds the repo rate

    Stocks of Indian banks which were under pressure before the repo rate review, regained hold in the banking space after the RBI left the existing repo rate unchanged. SBI, HDFC Bank and ICICI Bank are among the top banks which lead the gains in the Sensex on 7 December 2017. The stocks of ICICI bank and HDFC Bank resulted in the maximum upsurge of the Sensex among all banking components. Out of the total 205 points gain, around 45 points are added to the index by the stocks of these two banks.

    One day before this upcharge, The RBI Monetary Policy Committee of 6 members led by Urijit Patel kept the repo and the reverse repo rate on hold without making any revisions in the existing 6% and 5.75% rate. While the IndusInd Bank and the Kotak Mahindra Bank lost up to 0.02% in the Sensex after the hold, the ICICI Bank, Yes Bank, Bank of Baroda, PNB, Federal Bank, SBI, IDFC Bank, Axis Bank, Canara Bank and HDFC Bank leaded the gains with up to 1.34%, 1.29%, 1.18%, 1.1%, 0.93%, 0.93%, 0.56%, 0.4%, 0.36% and 0.36% respectively.

    12 December 2017

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