Please find below a good article by Mrs. Uma Sashikanth & Mrs. Deepa Vasudevan of CIEL with regard to bank action on RBI's rate actions for your reading:
How do banks respond to RBI's Rate Actions? Part 1 : Banks respond faster to hikes, not cuts:
As expectations for a lower interest rate regime are growing, the critical question to ask is whether banks would also reduce their lending rates. If the rate cuts from RBI, whenever they happen, are not transmitted through the banking channel to borrowers, revival of consumption and investment, and therefore economic growth may not be as fast as expected.
How have the lending rates or the base rates of the banking system behaved over time? The base rate is the minimum interest rate at which banks can lend. All rupee denominated domestic loans have to be made at or above the base rate[1]. A bank can have only one base rate. Banks are free to set their base rates on the basis of any benchmark, or by using any appropriate methodology, provided the method of fixing the base rate is consistently applied. The base rate is expected to include cost of funds, the opportunity cost of funds locked into SLR and CRR, some overhead costs, and some measure of profit. RBI norms required the base rate to be reviewed at least once in a quarter. Changes in the base rate have to be disclosed to the public in a transparent manner.
The base rate system came into force on July 1, 2010[2]. Before that, loans were priced with reference to a bank-specific benchmark Prime lending rate (BPLR). The key difference between the two systems is that banks were allowed to lend at rates below the BPLR. As a result lending rates were not transparent, and RBI was unable to assess if changes in policy rates were being effectively transmitted to bank lending rates. The adoption of a base rate system was expected to enhance transparency in loan pricing as well improve the monetary transmission mechanism.
In July 2010, when the system became operational, leading banks set their base rates at around 7.5%. Between March 2010 and April 2012, RBI increased the repo rate by a whopping 3.5%. Base rates also moved up to 10% in response to the rate tightening. The subsequent easing cycle- until July 2013- saw a 75 basis points decline each in repo rate and CRR, while the base rate fell into the range of 9.6% to 10%. Since the start of fiscal 2014-15, the base rate has remained at 10% (Pic 1).
Pic 1 Base Rates and Repo Rate
Source: RBI, Reuters, CIEL Research
It can be seen that the transmission from policy rates to the bank base rate is not symmetric. When rates went up in 2010 liquidity was tight, and an increase in policy rates was immediately transmitted to an increase in base rate. But when the RBI dropped rates in 2012 banks not only delayed the lowering of base rates, but also did not persist with it in 2013. This asymmetric monetary transmission dilutes the impact of monetary policy. RBI’s monetary policy actions are effective when it is tightening, but not as effective when it is easing. This one-way effectiveness has been observed by several studies, most recently in the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework, chaired by Shri Urjit Patel[3].
When RBI began to reduce rates in 2012, the banking system was caught in a situation of declining deposits and tight liquidity, which created a “wedge” between deposits and credit. During the 2010-2013 period, credit was growing faster than deposits. Insufficient deposit mobilisation prevented banks from cutting deposit rates. This, in turn, limited their ability to reduce the base rate. This structural deficiency was primarily responsible for the poor transmission of RBI’s rates cuts by the banking system. How the situation is different now in 2014, is what we will see in Part 2 of this blog.
Part 2: What are banks likely to do now, should RBI cut rates?
The situation in 2014, as the market awaits rate cuts from RBI, is exactly the opposite of what we saw in 2012 (see part 1 of this blog for that story on transmission of RBI’s interest rate policy): deposit growth has been much stronger than growth in bank credit (Pic 1). This build up in deposits has encouraged several banks to drop deposit rates. Overall liquidity is comfortable. Debt yields have fallen across tenors. Inflation is low, and declining. It is fairly certain that interest rates will be reduced next year. Despite all these favourable factors, base rates have remained at 10% for more than a year. Why have rates not declined? Some banks have announced that they will cut lending rates in April, but most remain uncommitted
Pic 1 Fortnightly Growth in Bank Deposits and Credit
Source: RBI
To answer this question, we need to look how banks raise their funds. Deposits are the primary source of funds of banks. As on November 28, 2014, deposits (savings deposits, current accounts, and time deposits) made up 91% of bank liabilities. Banks are not significantly dependent on the money market for funds. During periods of tight liquidity, they tend to borrow in the call money market, refinancing from RBI, or issue high-cost Certificates of Deposits (CDs). But when liquidity is ample, as it has been in 2014-15, their dependence on the money market is low. When RBI changes the policy rate, or the repo rate, it directly impacts rates in the money market.
The changes in the money market rates operate on the asset side of a bank’s balance sheet. CDs and CPs are market instruments whose prices almost instantaneously respond to rate cuts by RBI. A corporate borrower has the choice of issuing a CP or borrowing from the bank. When a bank is able to keep its deposit rates low, and therefore enjoy low cost of funds, it is able to price its loans competitively compared to a CP. However, if it has to lean on CDs to raise money, there is not enough spread to lend aggressively; nor is there enough elbowroom to reduce lending rates. A period of tight liquidity and high dependence on CDs, therefore naturally leads to a fall in growth rates of credit. The squeeze on bank profitability that comes from a high borrowing rate is eased when liquidity eases. Therefore deposit rates fall first, before lending rates can fall. Even they do so with a lag, since the impact of policy rate changes on deposit rates is indirect, as it operates through changes in interest rate expectations and inflation expectations. Therefore, banks cannot, and do not, match every drop in repo rate with a drop in deposit rates. There is an inevitable lag.
Even if banks are able to reduce deposit rates, the change is only at the margin. Existing deposits continue to be serviced at the older (and higher) rates until maturity. This creates a time lag between a fall in bank deposit rates and an actual drop in their cost of funds. The higher the proportion of longer tenor deposits in bank balance sheets, the longer it takes for a drop in deposit rates to reduce overall cost of funds. As on March 2013, 13% of the term deposits of scheduled commercial banks were for tenors upto 1 year, 50% for tenors of 1 to 3 years, and 36% for tenors over 3 years! Given the tilt towards long term deposits, it is not surprising that banks are reluctant to pass on the advantage of lower deposit rates by cutting their lending rates.
There are more stories to tell about the structural differences between PSU and private banks, and the burden of NPAs on bank balance sheets, which will constrain their pricing and lending actions. Those will have to wait until we are able to see the banking sector results for FY 2015 in April. In the JFM quarter no one speaks about reducing lending rates, given the seasonal tightness, anyway. Those stories can therefore wait.
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