What Stops Banks From Passing On Rate Cut Benefits?

It is a common observation that changes in the country's policy rates do not easily translate into changes in interest rates. According to a recent study of India Ratings, when the Reserve Bank of India (RBI) cuts the repo rate, deposit rates decline faster than lending rates. This means that the interest rate on savings of customers have declined faster than the interest rates banks charge borrowers. Similarly, when the RBI raises the repo rate, lending rates rise faster than deposit rates.

Even when banks cut the base rate, they raise the spread between the base rate and lending rate, negating some of the benefits to borrowers. In the current year, after the RBI cut the repo rate by 125 basis points, deposit rates of banks have declined by an average of 130 basis points and lending rates have declined by an average of 50 basis points.

A look at why monetary policy transmission in India is less efficient:

The spread between deposit rate and lending rate is high in India, when compared to developed economies and other major Asian countries. The reason is that Indian banks are subject to stringent statutory requirements and are compelled to lend to priority sectors, even if it is not profitable. Domestic banks, for instance, are expected to divert 40 per cent of their loans to priority sectors such as agriculture and micro and small enterprises. So, even though it seems that the spread is high, the gains from this spread is offset by such requirements. However, this means that such requirements hurt savers in India who earn a much lower interest rate on their savings, and borrowers (including home buyers) who are expected to pay higher interest rates.

The Benchmark Prime Lending Rate, the rate at which banks charge their most creditworthy customers, was in existence till July 2010. The RBI replaced the benchmark prime lending rate system with the base rate system in 2010, because banks often ignored this while charging interest rates on borrowers. But, even today, banks can raise or lower the spread to tinker with interest rates.

Monetary policy transmission depends greatly on what a committee report called the Bond-Currency-Derivatives nexus. This panel was headed by the current RBI Governor, Raghuram Rajan. When a central bank reviews policy rates in an advanced market, the changes in rates penetrate all areas of the economy. The changes in the policy rate reach the ultimate consumers through influencing the interest rates on government bonds, corporate bonds and currency and derivative markets. By allowing its markets to function more, the government may ensure the rate cut benefits reach the common people fast. 

A free competition between Indian and International banks may help lending rates fall adequately. While India's banking sector has yet to see a good number of domestic players, norms regulating the entry of foreign banks are also stringent, thus weakens competition. So, even when the RBI cuts the repo rate, banks feel less pressure to pass on the benefits.