In periods of negative growth, such as the one we found ourselves in throughout the pandemic, it is essential that policy actions intended to ease the economic blow to the nation fulfill their purpose.
As and when the RBI does slash its rates, it looks at targeting growth and inflation through a variety of channels. The most obvious impact of these rate changes would be on banks. After all, the policy repo rate is basically the cost at which the Central Bank lends funds to commercial banks on an overnight basis; the ultimate aim being overall credit growth in the economy. Then there are channels such as money market rates, inter-bank lending rates, corporate and government securities yields, asset prices and the forex market. While all these factors might be intriguing, they aren’t the root cause of the problem. The general consensus among policy experts is that financial markets are the first to respond, whereas other segments lag due to varying levels of market development, institutional set-up, and liquidity.
Even though the RBI cut policy rates by a massive 135 basis points during calendar year 2019, much greater than any other central bank in other parts of the world did, borrowers were barely affected. One sector in particular that had to bear the brunt of this staggered transmission was real estate. NBFC’s (Non-Banking Finance Companies) and HFC’s (Housing Finance Companies) are the major source of funds to real estate developers. These institutions in turn rely on banks for borrowing. The frustration of the Confederation of Real Estate Developers’ Associations of India (CREDAI) was clearly visible through their letter addressed to the RBI back in May 2020 – “While the RBI has reduced 2.50 per cent in repo rates since January 2019, the maximum reduction passed on by banks to the borrowers has been between 0.7-1.3 per cent, largely from August 2019 till date. In some cases, however, no benefit of repo rate reduction has been passed on at all”.
The central bank has revised the system used to calculate the spread between policy rates and lending rates multiple times, moving on from the flexibility and opacity of an internal benchmark mechanism to the transparency of an external benchmarking system. The actual lending rate now consists of a benchmark rate (repo rate, 91-day T-bill yield, the 182-day T-bill yield, or any other FBIL approved benchmark) plus the spread which takes into account risk premia, operating costs and profit margins. The problem with the earlier Base Rate and MCLR systems was that borrowers may not have gotten any respite from banks, even after a RBI rate cut announcement, making the entire transmission mechanism ineffective.
The reason why bank rates are so sticky is due to the rigidity on the liability side. Most deposits received by banks are based on a fixed rate, meaning that the transmission would only be effective for fresh deposits, and about 77% of term deposits have a one year + maturity. As a result, these deposit rates cannot be changed as frequently as the RBI alters its policy rates. So, even though the marginal cost of funds falls, the average cost of funds is slower in responding. Banks are hesitant in cutting lending rates since they would have to continue paying interest on deposits at the original rate, thus reducing their Net Interest Income (NII) spread.
Adding to this, depositors have other lucrative avenues to invest their savings in. With the increased risk appetite that comes with improved financial literacy, mutual funds have become an attractive alternative to a saving deposit. Furthermore, instruments such as National Savings Certificate and Public Provident Fund apply pressure on banks to keep their deposit rates competitive.
The end result of policy transmission is ultimately dependent on the structure and health of the banking system. The latter isn’t a matter to brag about. Investment by firms isn’t only dependent on the access to credit. It also critically hinges on the liquidity position of the bank itself. A working paper published by the Reserve Bank found – “Investments in fixed assets increase for firms that are attached to relatively more liquid banks when these banks increase their lending. By contrast, firms borrowing from the least liquid banks exhibit an increase in short-term capital in response to bank lending, presumably because less liquid banks cannot take on as much credit risk”. The same paper also used firm-bank matched data to point out that in the presence of a weak credit channel, expansionary monetary policy translates into banks reducing their current liabilities rather than raising their fixed capital expenditure.
Having been through the NPA crisis, a crisis which hasn’t been completely resolved, both public and private sector banks are struggling with weakened balance sheets. As a result, they are unable to step up lending even with lower funding costs and higher demand for credit. The gross NPA figures (6.8%) as on December 2020 may not provide an accurate picture of reality. This data hides the challenges that banks are set to face in 2021 since the effect of the loan moratorium and restructuring hasn’t completely set in yet. A Financial Stability Report by the RBI published in January 2021 stated that the Gross NPA Ratio may rise all the way to 13.5% by September 2021, with a possibility of surging to 14.8% under a severe stress scenario.
It’ll be interesting to see what these developments will mean for the transmission mechanism. Till then, all eyes on the Reserve Bank of India.
Dhruv Lowe Undergraduate Student at Shri Ram College of Commerce
References 1. https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=1162 2. https://rbi.org.in/scripts/BS_SpeechesView.aspx%3FId%3D1049″ target=”_blank”>“>“>
As and when the RBI does slash its rates, it looks at targeting growth and inflation through a variety of channels. The most obvious impact of these rate changes would be on banks. After all, the policy repo rate is basically the cost at which the Central Bank lends funds to commercial banks on an overnight basis; the ultimate aim being overall credit growth in the economy. Then there are channels such as money market rates, inter-bank lending rates, corporate and government securities yields, asset prices and the forex market. While all these factors might be intriguing, they aren’t the root cause of the problem. The general consensus among policy experts is that financial markets are the first to respond, whereas other segments lag due to varying levels of market development, institutional set-up, and liquidity.
Even though the RBI cut policy rates by a massive 135 basis points during calendar year 2019, much greater than any other central bank in other parts of the world did, borrowers were barely affected. One sector in particular that had to bear the brunt of this staggered transmission was real estate. NBFC’s (Non-Banking Finance Companies) and HFC’s (Housing Finance Companies) are the major source of funds to real estate developers. These institutions in turn rely on banks for borrowing. The frustration of the Confederation of Real Estate Developers’ Associations of India (CREDAI) was clearly visible through their letter addressed to the RBI back in May 2020 – “While the RBI has reduced 2.50 per cent in repo rates since January 2019, the maximum reduction passed on by banks to the borrowers has been between 0.7-1.3 per cent, largely from August 2019 till date. In some cases, however, no benefit of repo rate reduction has been passed on at all”.
The central bank has revised the system used to calculate the spread between policy rates and lending rates multiple times, moving on from the flexibility and opacity of an internal benchmark mechanism to the transparency of an external benchmarking system. The actual lending rate now consists of a benchmark rate (repo rate, 91-day T-bill yield, the 182-day T-bill yield, or any other FBIL approved benchmark) plus the spread which takes into account risk premia, operating costs and profit margins. The problem with the earlier Base Rate and MCLR systems was that borrowers may not have gotten any respite from banks, even after a RBI rate cut announcement, making the entire transmission mechanism ineffective.
The reason why bank rates are so sticky is due to the rigidity on the liability side. Most deposits received by banks are based on a fixed rate, meaning that the transmission would only be effective for fresh deposits, and about 77% of term deposits have a one year + maturity. As a result, these deposit rates cannot be changed as frequently as the RBI alters its policy rates. So, even though the marginal cost of funds falls, the average cost of funds is slower in responding. Banks are hesitant in cutting lending rates since they would have to continue paying interest on deposits at the original rate, thus reducing their Net Interest Income (NII) spread.
Adding to this, depositors have other lucrative avenues to invest their savings in. With the increased risk appetite that comes with improved financial literacy, mutual funds have become an attractive alternative to a saving deposit. Furthermore, instruments such as National Savings Certificate and Public Provident Fund apply pressure on banks to keep their deposit rates competitive.
The end result of policy transmission is ultimately dependent on the structure and health of the banking system. The latter isn’t a matter to brag about. Investment by firms isn’t only dependent on the access to credit. It also critically hinges on the liquidity position of the bank itself. A working paper published by the Reserve Bank found – “Investments in fixed assets increase for firms that are attached to relatively more liquid banks when these banks increase their lending. By contrast, firms borrowing from the least liquid banks exhibit an increase in short-term capital in response to bank lending, presumably because less liquid banks cannot take on as much credit risk”. The same paper also used firm-bank matched data to point out that in the presence of a weak credit channel, expansionary monetary policy translates into banks reducing their current liabilities rather than raising their fixed capital expenditure.
Having been through the NPA crisis, a crisis which hasn’t been completely resolved, both public and private sector banks are struggling with weakened balance sheets. As a result, they are unable to step up lending even with lower funding costs and higher demand for credit. The gross NPA figures (6.8%) as on December 2020 may not provide an accurate picture of reality. This data hides the challenges that banks are set to face in 2021 since the effect of the loan moratorium and restructuring hasn’t completely set in yet. A Financial Stability Report by the RBI published in January 2021 stated that the Gross NPA Ratio may rise all the way to 13.5% by September 2021, with a possibility of surging to 14.8% under a severe stress scenario.
It’ll be interesting to see what these developments will mean for the transmission mechanism. Till then, all eyes on the Reserve Bank of India.
Dhruv Lowe Undergraduate Student at Shri Ram College of Commerce
References 1. https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=1162 2. https://rbi.org.in/scripts/BS_SpeechesView.aspx%3FId%3D1049″ target=”_blank”>“>“>