The rate cut by the RBI is not resulting in commensurate interest cut by Banks. Discuss why.

Published: October 21, 2019

The Reserve Bank of India (RBI) has cut its lending rate to the banks by 135 basis points (or 1.35 percentage points) in the span of nine months. But there has been no commensurate rate cut by banks.

Why there has been no commensurate rate cut by Banks?

Distance between Repo Rate and Interest Rates
  • For a bank to be viable there must be a clear difference between the interest rate it charges from borrowers on loans it provides and the interest rate it gives to consumers on deposits it accepts.
  • The difference between these two interest rates has to be not only positive but must also be big enough for the bank to make profits.
  • Banks offer a high deposit rate to attract deposits. Such deposits make up almost 80% of all banks’ funds from which they then lend to borrowers and banks borrow a minuscule fraction under the repo.
  • As a result, sharply reducing the repo rate doesn’t change the overall cost of funds.
  • Hence the Repo rates have little impact on a bank’s overall cost of funds, and reducing lending rates because the repo has been cut is not feasible for banks.
Why Banks are hesitant to reduce interest rates?
  • Banks are worried that if they reduce the deposit rates, the depositors would shift to a rival bank that pays better interest rates or park more and more of their savings in small saving instruments such as public provident fund, Sukanya Samriddhi Yojana etc that pay much higher interest rates.
  • Also, Banks cannot reduce their deposit rates instantly since 65% of total deposits are “term” deposits (fixed for a certain duration) and take, on an average, up to two years to get repriced at fresh rates.
  • Hence banks are going slow on reducing the interest rates on advances as deposits take longer to get repriced.

Hence the transmission of repo rate cuts to interest rates is not happening at the pace the RBI is cutting the repo rates.

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