RBI has cut its policy repo rate by 75 bps in three tranches of 25 bps from January 2015 till early June. While some part of these cuts has been transmitted into lower bank base rates, there is a debate on why this is not happening at a faster pace. We attempts to break down the transmission channels of repo rate cuts on lending rates into quantum and rate components in order to explain the process.
First, in terms of quanta, transmission is influenced not just by prevailing liquidity conditions but also expectations of future liquidity. History is guide to this. Banks had gone through severely tight liquidity conditions in the second half of 2011, just prior to RBI starting the rate cut cycle in April 2012.
Banks had responded to the repo rate cuts, although not to the full extent, since liquidity conditions had remained tight, although not as severe. However, just about that time, global markets had become volatile, owing to fears of default by the peripheral countries of the eurozone. With a lag of about 10 months, the first set of relatively shallow repo rate cuts had been matched by cuts in base rates. The next round of deeper repo rate cuts (75 bps) started in January 2013, but again during a phase of tight liquidity in Q4FY13. By the time the final 25 bps cut was done on May 3, 2013, markets had become very volatile prior to the May “tantrum” following the US Fed announcement of tapering of its QE programme. The extraordinary liquidity tightening measures were announced on July 15. As of now, going forward, although not as big a concern, there remain some apprehensions on the effects of the Fed beginning to hike rates, although RBI remains committed to maintaining system liquidity consistent with the repo rate.
Second, changes in bank lending rates are determined not just by the quantum of liquidity but also its price. A change in the liquidity pricing framework post the Urjit Patel committee report on the Monetary Policy Framework resulted in a progressive shift away from fixed price (repo) Liquidity Adjustment Facility (LAF) injection to variable price term repo based liquidity injection. The proximate result of the changed mode of liquidity injection was to increase the spread of the weighted rate of injected funds from around zero prior to the new liquidity management framework to about 18-20 bps post the change.
While this might not seem a significant change, the ripple effects on the entire spectrum of money market rates raised the cost of borrowed funds of the banking sector by more than that of RBI injected funds. Chart 1 shows the effect of the liquidity management change on the 3-month Certificates of Deposit rates issued by banks.
The effect of money market rates is also transmitted to term deposit (fixed deposits) instruments of banks. Shorter maturity term deposits (TD) are most sensitive to the repo rate and liquidity conditions. However, TD rates at all maturities respond to policy rate changes.
These rate movements are important given the structure of deposits and borrowed funds of banking sector. Approximately two-thirds of banking sector deposit liabilities are TDs. Within the overall deposit structure, rate transmission also depends on the maturity structure of deposits. The basic premise of transmission depends on repricing of incremental deposits contributing to a gradual reduction in the cost of the outstanding deposit base of banks.
Chart 2 shows the maturity structure of TDs (66% of total deposits). TDs with maturity less than 3 months are only about 8% of total. These are the deposits which are expected to reprice lower after the repo rate cuts (i.e. in Q4 of FY15 itself). TDs between 3 to 6 months are another 6% and between 6 months to a year, 15%. The bulk of TDs are in the 1 to 2 year maturity bucket (34%), which is the time lag where the main transmission might be expected to happen.
Aggravating these trends is a deeper structural change in the dynamics of savings in India. Low cost and stable savings bank deposits constitute almost a quarter of total deposits of banks, which have progressively slowed down over the past couple of years, hypothesised as a fallout of falling household financial savings. This has forced banks to rely on higher cost TD, raising the blended cost of funds.
One criticism of banks has been at least some of the stickiness of base rates due to an effort to preserve Net Interest Margins (NIMs). Chart 3 shows a secular decline in banking sector NIMs over the last two decades. Over FY12-FY14, there has been a sharp drop in NIMs, reflecting progressive stress on banks.
There is some logic in preserving NIMs. In FY15, the share of banks in credit has fallen to about a third, down from half or more in previous years. In terms of total debt, banks’ credit share dropped from 67% in FY14 to about 50%. Disintermediation to non-bank sources has the potential to affect fees and thereby Returns on Assets (RoAs). This will have an adverse effect on the ability of banks not just to expand their presence in remote and low density centres but also meet the massive investment requirements of India’s growth.
In short, banks’ response to monetary policy easing seems largely rational, although the pace is debatable. What is certain is that further transmission is on the cards in the future.
(Abhay More and Tanay Dalal contributed to the article)
The author is senior vice-president & chief economist, Axis Bank.
Views are personal