Quick response by banks key to success of RBI action

21 April 2009

A time lag in banks responding to RBI's rate cut leads has only helped to negate gains of RBI action to the credit market and the economy in general, the central bank said in its annual monetary and credit policy review.

While banks have reduced lending and borrowing rates, RBI said, the efficacy of the monetary transmission mechanism hinges on the extent and the speed with which changes in the central bank's policy rate are transmitted through the term-structure of interest rates across markets.

''While the response to policy changes by the Reserve Bank has been faster in the money and government securities markets,  there has been concern that the large and quick changes effected in the policy rates by the Reserve Bank have not been fully transmitted to banks' lending rates. During the second half of 2008-09, while the Reserve Bank has reduced its lending rate (repo rate) by 400 basis points, most banks have lowered their lending rate in the range of 50-150 basis points,'' RBI noted.

''The adjustment in market interest rates in response to changes in policy rates gets reflected with some lag. However, the transmission to the credit market is somewhat slow on account of several structural rigidities, '' it added.

Banks, however, said they were constrained by the administered interest rate structure of small savings that acts as a floor to deposit interest rates. Without reduction in deposit rates, banks find it difficult to reduce lending rates exclusively on policy cues.

Also, while banks are allowed to offer 'variable' interest rates on longer-term deposits, depositors have a distinct preference for fixed interest rates on such deposits which results in an asymmetric contractual relationship. In a rising interest rate scenario, while depositors retain the flexibility to prematurely withdraw their existing deposits and re-deploy the same at higher interest rates, banks have to necessarily carry these high cost deposits till their maturity in the downturn of the interest rate cycle.