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Posted by: Deepa Vasudevan on Mon, Mar 25th, 2019

Effective Monetary Transmission: Work-in-Progress

Ineffective asymmetric monetary transmission has been a long-standing problem for RBI and policy makers in the Finance Ministry. Banks are quick to increase interest rates when monetary policy is tightened, but slow to cut rates when policy is eased. For example, while the policy repo rate remained unchanged between August 2018 and January 2019, and was cut by 25 bps in February 2019; the minimum lending rate of SBI increased by 30 bps in this period! If banks were pushed in the opposite direction of the desired monetary stance, clearly, transmission was ineffective (Pic 1).

 

Pic 1: Key Interest Rates

 

Banks were not able to pass on the repo cuts to their borrowers for two main reasons. First, systemic liquidity has been tight for several months now. The IL&FS default and subsequent risk aversion to lending to NBFCs contributed to tightening liquidity in Q3FY19. The liquidity position in the next quarter-Q4FY2019- has been worsened by lower government spending. At the same time, bank credit has picked up significantly, growing by double digits year-on-year; while growth in bank deposits is lagging behind (Pic 2). 

 

Pic 2: Galloping Credit, Lagging Deposits

 

In this situation, the decision by SBI to link its deposit and lending rates to the repo rate could be a turning point in India’s monetary history. From May 1, savings accounts with deposits over Rs. 1 lakh will earn 2.75% lower than the repo rate, while cash credit accounts and overdrafts with limits above Rs. 1 lakh will be levied interest at a minimum of 2.25% above the repo rate. SBI will charge a risk premium on these loans based on the risk profile of the borrower. Each time RBI tweaks the repo rate, it will automatically be passed on to these deposit and lending rates. 

The impact of SBI’s decision is not clear yet. Experts have pointed out that this move does not impact about 68% of SBI’s deposits; so that a 25 bps change in repo rate may result in barely 6- 7 bps change in MCLR[1]. Also, other banks have not yet followed suit. One possibility is that banks are waiting for the first monetary policy review of FY20 in early April, in order to assess the liquidity situation and RBI’s monetary policy stance. It is also likely that banks will wait for the outcome of national elections before taking steps that significantly alter their cost of funds or interest rate margins.   Finally, given the stack of bad loans in the banking system, banks are more focused on staying profitable after providing for NPAs, rather than on passing rate cuts to customers. Until bank balance sheets are stronger, it may not be easy for them to take steps that could potentially reduce their interest margins.

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[1] See T T RamMohan: SBI makes a Smart Move, Business Standard, March 19, 2019, for a detailed analysis. Available at https://www.business-standard.com/article/opinion/sbi-makes-a-smart-move-119031900054_1.html

 

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