How RBI is putting the onus on banks

Policy transmission through fiat may be regressive.

Living up to widespread expectations, the Reserve Bank of India maintained the status quo on the repo rate.

There were greater expectations of a cut in the cash reserve ratio and perhaps that the statutory liquidity ratio would be reduced, but those were not fulfilled.

The main reason that there were such low expectations about a repo rate cut was the anticipated impact of adverse weather conditions on the rabi crop.

While wheat prices are manageable through open market sales from the government’s stock, other crops, particularly vegetables, are likely to see prices rise, even if temporarily.

Whether monetary policy should respond to such transitory shocks is a debate in itself; but, as it happened, the primary rationale provided by the RBI for maintaining the status quo was not the threat of food prices surging.

Rather, it was the recalcitrance on the part of banks against passing on the two recent policy rate cuts by lowering their lending rates.

This lack of transmission has been widely commented on in recent days.

The chairperson of the State Bank of India attributed this to a higher average cost of funds as depositors switched funds from savings accounts to term deposits in order to protect themselves from falling interest rates.

It appears that monetary policy is caught in a chicken-and-egg trap.

Banks won’t lower lending rates because their cost of funds is not going down; in fact, it is increasing in response to the RBI rate cuts, because of substitution.

And now, the RBI will not lower rates until it sees banks doing so.

So what will break this logjam?

In the short term, there is cause for concern. Most leading banks have already cut their base rates.

It is reasonable to presume that the RBI’s stance on the matter has persuaded the banks to overcome their reluctance to cut rates.

The finance ministry has also been known to pressure public sector banks into lowering lending rates even when the RBI was moving in the opposite direction.

What could have stopped it from doing so now, particularly when the RBI also wants this to happen?

Effectively, monetary policy transmission may move from market forces to fiat -- which would be regressive.

And if good governance prevails and the ministry restrains itself, there is no stimulus to growth coming from monetary policy.

In the longer term, the policy itself proposes two substantial remedies to this problem.

Based on the premise that banks that price their loans on the basis of marginal rather than average cost of funds will be more responsive to policy rate changes, the RBI is encouraging banks to amend their pricing formulae to reflect marginal costs.

More fundamentally, the establishment of a new entity, Financial Benchmarks of India, which will develop and monitor market-based benchmarks, will allow banks to transit from cost-based pricing to external benchmark-based pricing, which will contribute to competitive efficiency.

Both these are promising developments in the effort to improve monetary transmission.

Tuesday’s policy announcement also had a regulatory and development component.

Two initiatives deserve mention.

One, along with a rejig of priority sector norms, the concept of priority sector lending certificates, proposed almost a decade ago by the Committee on Financial Sector Reforms -- led by the current governor -- has been resuscitated.

Properly designed and implemented, this should incentivise more lending to these sectors.

Two, new and presumably more pragmatic guidelines are being framed for compensation to non-executive directors of banks. Better governance should ensue.