Current General Studies Magazine (December 2015)

General Studies - III "Economy Based Article" (Who benefits when the RBI cuts rates?)

With the Reserve Bank of India (RBI) cutting policy rates, the question in everyone’s mind (at least in financial circles) is, when will this translate into a lower cost of borrowing for firms and consumers? Like most questions in economics, the answer is not straightforward. Let us begin by looking at what happened in the past under similar circumstances. In a study of interest rate transmission in India, Sonali Das, of the International Monetary Fund (IMF) finds that in recent years, changes in RBI rates have resulted in slow changes in bank deposit and lending rates. Not surprisingly, banks are quick to decrease deposit rates in the face of rate cuts, but not too eager to reduce lending rates. The opposite is true in the case of rate increases. Lending rates go up quickly, deposit rates lag behind. Dr. Das also shows that the speed of adjustment has improved over time. Overall, this paints a picture of a greedy banker profiting at the expense of hapless customers. The Monetary Policy Report of the RBI dated September 2015 confirms that this is the case with the current round of easing as well. Reflecting the frustration with the rate of transmission, the RBI Governor has recently taken to the airwaves to exhort banks to cut interest rates in response to his policy rate cuts. As we will see, the reasons for the slow rate transmission are many. While some are specific to India, others are not.

What is supposed to happen when the RBI cuts rates? Money is a bank’s raw material. An RBI rate cut is like a fall in raw material prices from an important supplier. As anyone with some business experience knows, if an important supplier cuts prices, it is not long before others (such as deposits) follow suit. Whether a company passes the lower cost to its customers or not depends on how competitive the market for its product is. If the company is fiercely competing for customers — think India’s mobile market — a fall in raw material prices will quickly translate into lower product prices. That is, following rate cuts, loan interest rates will fall. If on the other hand, the company enjoys monopoly power, it will have no pressure to pass on the lower costs. So the question is, why are Indian banks acting as if they have monopoly power?

The largest firms in the economy raise finance in very competitive markets. If the State Bank of India does not reduce interest rates for, say, Reliance Industries Ltd. following the RBI rate cut, the company will quickly shift its borrowing either to the commercial paper market or to another bank, say ICICI. This is already happening. There is an increase in issuance of commercial paper and bonds by large corporates. Small borrowers and households, on the other hand, do not have access to alternative sources of finance and so the banks do have some monopoly power over them — at least in the short run. Hence, they do not immediately benefit from the rate cut. This is true for most countries and not unique to India.

Monetary transmission

There are two other problems unique to the current time period and India in particular that impede monetary transmission. The first is the pressure on banks to increase equity financing and reduce their reliance on risky debt financing. This is a new focus for regulators following the financial crisis in the U.S. which highlighted the dangers of an over-reliance on debt financing. When faced with a rate cut, decreasing deposit rates and not reducing loan rates is an easy way for banks to increase their interest margin, and hence their profits. Since profits are a form of equity, this will help them shore up their balance sheets. By not aggressively cutting loan rates, banks may lose some of their best customers. In the current environment, Indian banks welcome that because it slows loan growth and the need to raise more equity. The amount of equity banks need is determined based on the amount of loans they make.

Thus the speed of monetary transmission, especially on the downside, will be slow if banks are not well capitalised and face pressure from regulators to increase their capital buffer. This was also the experience of the European Central Bank (ECB) recently when it implemented quantitative easing.

Now we come to the icing on the cake in the case of India that further impedes transmission. That is the government ownership of large banks. A government bank’s ability to increase equity is dependent on the government’s disinvestment programme and its decision to infuse equity in the banks. Since banks do not control the decision to raise equity, they move the levers under their control, which is to increase interest margin and slow loan growth. Thus, the rate of monetary transmission is captive to the government’s decision to shore up bank balance sheets.
 

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