The RBI announced the change in bank rate and repo rate in June 2018. This announcement was made as a part of the second bi-monthly monetary policy statement of RBI. The bank rate was increased from 6.5% to 6.75%, an increase of 25 basis points and the repo rate has been increased from 6.25% to 6.50%.
The repo rate and bank rate are used to regulate the money supply in the economy. If the repo rate is high, the commercial banks will purchase fewer securities from the central bank and the financial institutions will also get their fundings at a higher rate. At the same time, if the repo rate is low, the money supply in the economy will expand, and the financial institutions get their fundings at a relatively lower rate.
What causes monetary transmission to be slow?
Money is regarded as a bank's primal matter. When RBI lowers the rates, it triggers price cuts downstream, i.e., deposit rates and lending rates in the case of banks.
- The competition existing in the market decides whether a bank chooses to pass on the low prices to its customers or not. If the bank operates as a monopoly in the industry, it will try not to transmit the cut in interest rates to its customers. The banks aren't under any obligation to pass on the lower prices to consumers. The case is similar for Indian Banks as well.
- Since small borrowers and families which don't have any alternative sources of finance; banks exercise a monopoly over them. This is one of the central reasons for policy rate cuts not infiltrating into the small borrowers spontaneously. However, it is true for most of the developing countries, and not just for India.
- Sometimes, banks find it challenging to lessen the lending rates in the short term due to the fixed interest rate on the deposit contracts. Also, these banks face competition from the small savings instruments, which makes it challenging to reduce the rates that depositors are offered.
- Another issue that hinders monetary transmission is the burden on banks to enhance equity funding and decrease any form of risky debt financing. This problem is relevant specifically to the current financial landscape within India.
- The current focus originates from the financial crisis in the U.S. that pulled attention to the perils of debt financing and the excessive dependence of the Indian banks on it. At the time of a policy rate cut, decreasing the deposit rates (and not the loan rates) is a suitable way for the banks to raise their interest margin. This paves the way for increased profits that are accrued in the form of equity.
- The level of equity required by banks is delimited by the quantum of loans that they provide. When the banks don't cut lending rates immediately, there is a possibility that they lose their customers. The current financial environment admits that the banks incur losses because it impedes the growth of loans.
- Consequently, the speed at which rate cuts move will be delayed if the banks are facing pressure from the regulators to raise their capital buffer.
- Ownership of the banks by the government also acts as an inhibition to monetary transmission. The power of a government-owned bank to raise the equity depends on its disinvestment plan and the decision to instill equity. Since banks do not have a say in this decision, they increase the interest margin and slow growth of loans. Hence, monetary transmission, in this case, is subject to the government's decision to soar the balance sheets of banks.
- Some commercial banks have intimated that a CRR cut will invariably bring about traction in monetary transmission. A justified reduction in CRR, aside from injecting additional liquidity into the system, also frees the bank's resources to lend and helps the banks in transferring the rate cuts without impacting their interest margin adversely.
- While this is an excellent tool to control inflation, RBI often uses the money transmission tools as a monetary policy after factoring in the condition of the Indian economy and inflation levels for monitoring the market inflation and managing the liquidity of the economy. However, this process might not prove to be useful if the banks aren't ready to transmit the rate cut to their customers.
The crux of monetary transmission is that apart from the apparent lag in monetary transmission, banks rarely meet the RBI rate cuts. However, additional rate cuts and liquidity support measures are required for encouraging banks to lower interest rates in the future.