FINANCIAL

INSTITUTIONS AND MARKETS

PROJECT

AN OVERVIEW OF
RBI CREDIT POLICY,
MONETARY POLICY COMMITTEE,
IMPACT OF COVID-19
AND
RECENT RATE CUT
IN RELATION TO
THE INDIAN FINANCIAL SYSTEM

Submitted to:
Dr. P. N. Rath

Submitted by:
Pallavi Agrawalla
B.B.A L.L.B ‘B’ (2nd Year)
Roll Number - 1882127
 RBI CREDIT POLICY
Credit and Monetary policy is the macroeconomic policy laid down by the central bank. It
involves management of money supply and interest rate and is the demand side economic
policy used by the government of a country to achieve macroeconomic objectives like inflation,
consumption, growth and liquidity. In India, monetary policy of the Reserve Bank of India is
aimed at managing the quantity of money in order to meet the requirements of different sectors
of the economy and to increase the pace of economic growth. The RBI implements the
monetary policy through open market operations, bank rate policy, reserve system, credit
control policy, moral persuasion and through many other instruments. Using any of these
instruments will lead to changes in the interest rate, or the money supply in the economy.
Monetary policy can be expansionary and contractionary in nature. Increasing money supply
and reducing interest rates indicate an expansionary policy. The reverse of this is a
contractionary monetary policy. For instance, liquidity is important for an economy to spur
growth. To maintain liquidity, the RBI is dependent on the monetary policy. By purchasing
bonds through open market operations, the RBI introduces money in the system and reduces
the interest rate.

The main objectives of Monetary Policy are:

• To maintain price stability.

• To ensure adequate flow of credit to productive sectors so as to assist growth.
• Arrangement of full employment.
• Expansion of credit facility
• Equality & Justice Stability in exchange rate.
• Promotion of Fixed Deposit.
• Equitable distribution of Credit.

The Monetary and Credit Policy is the policy statement, traditionally announced twice a year,
through which the Reserve Bank of India seeks to ensure price stability for the economy.
Monetary Policy of India is formulated and executed by Reserve Bank of India to achieve
specific objectives. It refers to that policy by which central bank of the country controls (i) the
supply of money, and (ii) cost of money or rate of interest, with a view to achieve particular
objectives. The monetary policy is defined as discretionary act undertaken by the authorities
designed to influence (a) the supply of money, (b) cost of money or rate of interest, and (c) the
availability of money for achieving specific objectives. Thus, monetary policy of India refers
to that policy which is concerned with the measures taken to regulate the volume of credit
created by the banks, to regulate the expansion of money supply and money circulation in the
country. Main objectives of monetary policy are to achieve price stability, financial stability
and adequate availability of credit for growth. Following are the Main elements of the monetary
policy of India: (i) It regulates the stock and the growth rate of money supply. (ii) It regulates
the entire banking system of the economy (iii) It regulates the level and structure of interest
rates directly in organised sector and indirectly in unorganised sector. (iv) It determines the
allocation of loans among different sectors. (v) It provides incentives to promote savings and
to raise the savings-income ratio. (vi) It ensures adequate availability of credit for growth and
tries to achieve price stability.
Following are the main features of the monetary policy of the Reserve Batik of India:
• Active Policy Before the advent of planning in India in 1951, monetary policy of RBI was
a passive policy. RBI did not use the measures of monetary policy to regulate the
 availability of credit. For example, from 1935 to 1951, the bank rate remained stable at 3%.
But since 1951, RBI has been following an active monetary policy- It has been using all
the measures of credit control.
• Controlled Money Supply Monetary supply of RBI has been achieving contradictory
objectives of economic growth and controlling inflation. For promoting economic growth,
more money supply is needed, while to control inflation money supply has to be curbed. If
RBI feels that more credit is required for economic growth, then it expands credit. But if
RBI feels that inflation is rising then it restricts credit. Thus, RBI controls money supply to
achieve these contradictory objectives.97
• Seasonal Variations The monetary policy is characterised by the changing behaviour of
busy and slack seasons. These seasons are tied to the agricultural seasons. In the busy
season, there is an expansion of funds on account of the seasonal needs of financing
production, and inventory building of agricultural commodities. On the other hand, during
slack season, there is less demand for funds. Thus, during the busy season the Reserve Bank
expands credit, and during the slack season, RBI contracts credit
• Flexible Monetary policy has been changed according to change in market conditions and
requirements. If, there is more requirement of funds in the market, then RBI follows liberal
monetary policy by lowering bank rate, CRR, repo rates, interest rates, etc. For example, at
present, economy needs more funds for economic growth, so RBI has given liberal
monetary policy. On the other hand, when inflation is very high, then RBI decreases supply
of money (to check inflation) by adopting tight monetary policy.98
• Investment and Saving Oriented - To encourage investment, rate of interest on loan should
be low, while to encourage saving rate of interest on deposits should be high. The monetary
policy adopted by Reserve Bank is both investment and saying oriented. To encourage
investment, adequate funds and loans are made available for productive purposes at
reasonably low rates of interest. The Reserve Bank has also kept the interest on deposits at
a reasonably high rate to attract savings.
• Wide Range of Methods of Credit Control - The Reserve Bank has used a wide range of
instruments of credit control. It has adopted all the measures of quantitative and qualitative
credit controls to regulate credit as per the needs and requirements of the economy
Credit Control means the regulation of the creation and contraction of credit in the economy.
It is an important function of central bank of any country. The importance of credit control has
increased because of the growth of bank credit and other forms of credit. Commercial banks
increase the total amount of money in circulation in the country through the mechanism of
credit creation. In addition, businessmen buy and sell goods and services on credit basis.
Because of these developments, most countries of the world are based on credit economy rather
than money economy. Fluctuations in the volume of credit cause fluctuations in the purchasing
power of money. This fact has far reaching economic and social consequences. That is why,
credit control has become an important function of any central bank.
Credit control is an important tool of the monetary policy used by Reserve Bank of India
(central bank) to control the demand and supply of money and flow of credit in an economy.
RBI keeps control over the credit created by commercial banks.
The central bank is usually given many weapons to control the volume of credit in the country.
The use of these weapons are guided by the following objectives.
(i) Stability of Internal Price-Level The commercial bank can create credit because their
main task is borrowing and lending. They create credit without any increase in cash
with them. This leads to increase in the purchasing power of many people which may
lead to an increase in the prices. The central bank applies its credit control to bring
 about a proper adjustment between the supply of credit and measures required to that
effect in the country concerned. This helps in keeping the prices stable under control.
(ii) Checking Booms and Depressions The operation of trade cycles causes instability in
the country, so the objective of the credit control should be to reduce the uncertainties
caused by these cycles. The central bank adjusts the operation of the trade cycles by
increasing and decreasing the volume of credit.
(iii) Promotion of Economic Growth The objective of credit Control policy in backward and
underdeveloped countries should be to promote economic growth within the shortest
possible time. Generally speaking, the economic development in these countries is
retarded on account of lack of financial resources. Hence, the Central Banks in these
countries often try to solve the problems of financial stringency through planned
expansion of bank credit.
(iv) To Regulate and Expand Banking RBI regulates the banking system of the economy.
RBI has expanded banking to all parts of country. Through monetary policy, RBI issues
directives to different banks for setting up rural branches for promoting agricultural
credit. Besides it, government has also set up cooperative banks and regional rural
banks. All this has expanded banking in all parts of country.
(v) Stabilisation of the Money Market According to some economists the credit control
policy of the Central Bank should aim at the stabilisation of the money market in the
country. To achieve this objective, the Central Bank should neutralize seasonal
variations in the demand for funds. It should for example, provide extra credit in times
of emergencies. In fact, the control on credit should be exercised by the Central Bank
in such a manner as to bring about an equilibrium in the demand and supply of money
at all times.
(vi) Stability in Exchange Rates This is also an important objective of credit control. Credit
control measures certainly influence the price level in the country. The internal price
level affects the volume of exports and imports of the county which may bring
fluctuations in the foreign exchange rates. While using any measure of credit control,
it should be ensured that there will be no violent fluctuation in the exchange rates.
(vii) Preparation for war and other Emergencies Sometimes the objective of the Central bank
is to prepare the country for war through expansion of credit to enable the Government
to meet its financial requirement. Modem wars are so expensive that it is not possible
to meet their costs without adequate expansion of bank credit. During the second world
war almost every country resorted to expansion of credit on a large scale to meet the
rising war expenditure
The efficacy of the emerging operating procedures of monetary policy remains a matter of
debate. There is very little doubt that the Reserve Bank is now able to set an informal corridor
through two-way day-to-day liquidity management. The pass-through to the credit market,
however, does not appear very effective because of a variety of factors such as the overhang of
high cost deposits, large non-performing assets and high non-operating expenses in the banking
system. As a result, real interest rates continue to remain high. This underscores the need to
further strengthen structural measures to impart the necessary flexibility to the interest rate
structure in the credit markets. The phasing out of ad hoc Treasury Bills and the enactment of
Fiscal Responsibility and Budget Management (FRBM) legislation are two important
milestones in providing safeguards to monetary policy from the consequences of fiscal
expansion and ensuring better monetary-fiscal co-ordination. The RBI‟s vision documents at
presently has also required to be adequately focused on regulation and supervision of payment
systems so as to provide a safe, secure, efficient and sound mechanism which would match
international standards and best practices.
 ROLE OF MPC ON FRAMING OF CREDIT POLICY
In January 2007, the Reserve Bank of India (RBI) reconstituted its Technical Advisory
Committee (TAC) on Monetary Policy (which was first set up in July 2005) with a view to
obtaining continued benefit of advice on the stance of monetary policy from external experts
in the areas of monetary economics, central banking, financial markets and public finance and
their contribution towards enriching the inputs and processes of policy setting. The
reconstituted TAC, which has a tenure up to January 31, 2009 has five external members and
two members of the Central Board of the Reserve Bank. The Committee is chaired by the
Governor, with the Deputy Governor in charge of monetary policy as vice-chairman and other
Deputy Governors as members. The direction of institutional change appears to be indicative
of a preference for strengthening the consultative process of monetary policy formulation,
although the role of the TAC at the current juncture is unambiguously set out in the Governor’s
Annual Policy Statement for the year 2007-08: “It may be noted that the TAC is advisory and
provides guidance to the making of policy from time to time. As such, the responsibility,
accountability and time paths for decision making are not formally constrained by the meetings
of the TAC” (RBI, 2007).
The institution of the MPC is rapidly gaining ground across central banks, reflecting a growing
preference for not only collectivism in decision making but also for bringing to the table diverse
perspectives, new and independent thinking, technical expertise and experience, information
efficiency and pooling of analysis. On these grounds, a sufficiently empowered MPC with a
clearly defined target and freedom to adjust its instruments in order to achieve that goal can
offer the classic benefit of diversification: a higher mean with a lower variance. In the surveyed
literature and country practice, however, there is no clear cut case for decisions by committee
being better than more autocratic processes. It is argued that while the MPC may promote
discussion and information sharing, it also risks freeriding. Majority voting may weaken
accountability and may also reduce the informational efficiency of decision making.
In India, the approach to reform has been gradualist including in the context of the monetary
policy framework. The institution of the TAC reflects this choice of pace and sequencing. The
reconstitution of the TAC, whereby external members currently outnumber internal members,
is indicative of the qualitative enrichment that it has brought to the decision-making process.
All this has come about without changing the legal/institutional framework.
The specific characteristics of the Indian economy, including the ‘realpolitik’, perhaps, render
unified and centralised decision making responsibility and authority for monetary policy
necessary. There are notable differences between central banks and corporate entities. Central
banks are public policy institutions invested with socio-economic mandates which require
governance arrangements that balance autonomy and accountability. This is particularly
relevant in an emerging economy setting, as borne out by the country experience, where the
Governor chairing the Board has made a substantial difference to the atmosphere of discussion
and has not constrained disagreement on substantive matters.
Monetary policy decisions by central banks can have far-reaching implications for the
economy, investors, savers and borrowers. And if seen to be taken by an individual, these
decisions can cause a lot of heartburn. Therefore, globally many governments have solved this
problem by appointing a committee.
On June 27, 2016, the Government amended the RBI Act to hand over the job of monetary
policy-making in India to a newly constituted Monetary Policy Committee (MPC). The new
MPC is to be a six-member panel that is expected to bring “value and transparency” to rate-
setting decisions. It will feature three members from the RBI — the Governor, a Deputy
Governor and another official — and three independent members to be selected by the
Government.
Until recently, India’s central bank used to take its monetary policy decisions based on the
multiple indicator approach. Its rate decisions were expected to take into account inflation,
growth, employment, banking stability and the need for a stable exchange rate. Thus, RBI (with
the Governor as the focal point) would be subject to hectic lobbying ahead of each policy
review and trenchant criticism after it. The Government would clamour for lower rates while
consumers bemoaned high inflation. Bank chiefs would want rate cuts, but pensioners would
want high rates. RBI ended up juggling all these objectives and focussing on different
indicators at different points in time.
To resolve this, RBI set up an Expert Committee under Urijit Patel to revise the monetary
policy framework, and it came up with its report in January 2014. It suggested that RBI abandon
the ‘multiple indicator’ approach and make inflation targeting the primary objective of its
monetary policy. It also mooted having an MPC so that these decisions could be made through
majority vote. Having both Government and RBI members on the MPC was suggested for
accountability. The Government would have to keep its deficit under check and RBI would
owe an explanation for runaway inflation.
The Monetary Policy Committee of India is responsible for fixing the benchmark interest
rate in India. The meetings of the Monetary Policy Committee are held at least 4 times a year
and it publishes its decisions after each such meeting.
The committee comprises six members - three officials of the Reserve Bank of India and three
external members nominated by the Government of India. They need to observe a "silent
period" seven days before and after the rate decision for "utmost confidentiality".
The Governor of Reserve Bank of India is the chairperson ex officio of the committee.
Decisions are taken by majority with the Governor having the casting vote in case of a tie. The
current mandate of the committee is to maintain 4% annual inflation until 31 March 2021 with
an upper tolerance of 6% and a lower tolerance of 2%.
The Reserve Bank of India Act, 1934 was amended by Finance Act (India), 2016 to constitute
MPC which will bring more transparency and accountability in fixing India's Monetary Policy.
The monetary policy is published after every meeting with each member explaining his
opinions. The committee is answerable to the Government of India if the inflation exceeds the
range prescribed for three consecutive months.
Key decisions pertaining to benchmark interest rates used to be taken by the Governor of
Reserve Bank of India alone prior to the establishment of the committee. The Governor of RBI
is appointed and can be disqualified by the Government anytime. This led to uncertainty and
resulted in friction between the Government and the RBI, especially during the times of low
growth and high inflation. Before the constitution of the MPC, a Technical Advisory
Committee (TAC) on monetary policy with experts from monetary economics, central banking,
financial markets and public finance advised the Reserve Bank on the stance of monetary
policy. However, its role was only advisory in nature.
India’s shift to an MPC, driven by a clear inflation-targeting framework, if it succeeds, may
also ensure that consumers and investors can look forward to lower inflation rates over the
long-term. The public disclosure of MPC deliberations will also tell you why its members
batted for higher or lower rates.
 IMPACT OF COVID-19 ON INDIAN FINANCIAL SYSTEM
The constantly evolving Covid-19 pandemic has cast a long shadow on the global economy,
which was already jolted by the US-China trade war. With fears of a global recession on the
horizon, Covid-19 appears to have dealt the global economy a triple-whammy: massive supply-
chain related disruptions across a range of industries from containment efforts in China and
other economies; amplification of demand-side shocks due to uncertainties as well as
lockdowns and other containment measures domestically; and propagation of financial shocks
and the US dollar credit crunch.
This global shock comes at a particularly inopportune time for India, as the economy was
already on a very concerning downward trajectory since the turn of FY 2018-19 (Chart 1).
More specifically, on a quarterly basis, India’s growth rate fell from around 8 per cent in Q4
FY18 to a new low of 4.5 per cent in Q2 FY20.
Indeed, in its January 2020 update to the World Economic Outlook, the International Monetary
Fund (IMF) downgraded India’s growth estimates for 2019 to 4.8 per cent — the lowest for
over a decade — and sharply revised its 2020 growth forecast to 5.8 per cent, down 1.2
percentage points from the previous forecasts. These downgrades happened even before the
onset of the pandemic, and now look overly optimistic.
The roots of India’s economic drag in recent years can be traced back to the aftermath of the
drastic demonetisation experiment, which led to significant collateral damage, and the effects
of the rollout of the GST. While both these supply-side measures may have been well-intended,
they have certainly contributed to marked economic disruptions and led to a deeply entrenched
slowdown in the informal sector.
This has, in turn, been exacerbated by acute banking sector problems, with banks being saddled
by non-performing assets (NPAs) partly driven by “crony capitalism” stemming from the close
nexus between banks and large “politically connected” businesses, giving rise to dubious
lending practices and bad loans. Added to these banking woes has been a generalised credit
crunch in the financial system due to stresses in the non-bank financial sector, especially
following the collapse of Infrastructure Leasing & Finance Services (IL&FS).
On the external front, India’s economic struggles have been somewhat complicated by the
uncertainties triggered by the US-China trade war. Although India’s relatively limited presence
in the global value chains (GVCs) allowed it to be somewhat insulated from the trade war, it
was nevertheless a missed opportunity to benefit from potential investment diversion from
China. India’s inability to exploit investor interest in looking beyond China (as Vietnam has,
for instance), is a failure of the country’s flagship “Make in India” initiative which seems to be
becoming an excuse to revert to a degree of protectionism rather than of enhancing export
competitiveness per se.
The immediate economic and market impacts of the coronavirus have been on India’s financial
markets as well as the rupee, which hit a new low vis-à-vis the US dollar in March due to global
risk-off sentiment. For firms laden with dollar-denominated debts, a continuous weakening of
the rupee is likely to intensify their struggles to repay their obligations. Beyond the financial
shocks, India has to urgently find a way to cushion the demand-side shocks induced by
potential lockdowns and other ongoing containment measures.
Although the recent drop in oil prices offers some reprieve, it is inevitable that India will have
to undertake more aggressive counter-cyclical fiscal measures at some stage to buffer against
acute negative shocks arising from the spread of Covid-19.
Further, a country-wide lockdown in and of itself may not prove sufficient to stop large-scale
community transmission, as the virus can make a comeback once such restrictions are lifted
unless eradication efforts are complemented by extensive testing measures and a rigorous
follow-up in terms of aggressive contact tracing and subsequent targeted isolation. Although
an appropriate fiscal response is imperative to uplift the economy and especially assist the most
vulnerable, a massive fiscal expansion of the type envisaged by many other countries is likely
to exceed the fiscal targets set by the FRBM (the reprieve provided by low oil prices
notwithstanding). This would imply that the government has to either invoke the escape clause
or ignore the rule temporarily with the hope of returning to a path of fiscal consolidation once
the Covid-19 storm has been weathered.
Given the limited fiscal space India has compared to its East Asian counterparts, the onus may
well fall on the Reserve Bank of India (RBI) to do more heavy lifting in these times of growing
economic distress. To that end, the Central bank has also taken some steps to ease the dollar
credit crunch via long-term repo operations (LTRO) and offered a $2-billion swap for six
months to ease the pressure on the rupee, although it has not been part of the coordinated action
by central banks in taking even more aggressive measures to counter the heightened volatility
and adverse economic fallout from the coronavirus. Even if the RBI rolls out more aggressive
measures, the broader concern that still remains is the inadequate monetary policy transmission
that limits the effectiveness of any monetary stimulus in India, especially in the context of an
impaired financial sector.
Rating agency Moody’s on Thursday revised the outlook for the Indian banking system to
negative from stable, citing disruptions in economic activity caused by the covid-19 outbreak
and an ensuing decline in asset quality. It said asset quality will deteriorate across corporate,
small and medium enterprises (SME) and retail segments, leading to pressure on profitability
and capital for lenders. While funding and liquidity at public sector banks (PSBs) will be stable,
Moody’s said, the growing risk aversion in the system following the Yes Bank default will
increase funding and liquidity pressure on small private sector lenders.
“A deterioration of global economic conditions and a 21-day lockdown imposed by the Indian
government in an effort to slow the spread of coronavirus will weigh on domestic demand and
private investment," it said, adding that credit supply to the economy will be hampered by
volatility in global financial markets and heightened risk aversion among Indian banks and debt
market participants.

According to Moody’s, the stress among non-bank financiers will limit their capacity to lend,
further hindering India’s economic growth which was on a decline prior to the covid-19
outbreak. The rating agency said the rise in provisions and fall in revenues will hurt banks’
profitability, leading to a deterioration of capitalization. The agency, nevertheless, believes that
funding and liquidity at PSBs will be stable because public trust in them will remain strong due
to sovereign backing, unaffected by the Yes Bank default.

One can only hope that the acute economic challenges already faced by the country, which will
only be exacerbated by the Covid-19 pandemic, will persuade Prime Minister Modi’s
government to refocus its priorities towards dealing with economic stabilisation and upliftment
rather than pursue the more controversial aspects of its social and political agenda. The need
of the hour is unity of purpose.
 ROLE OF THE RECENT RATE CUT OF THE CENTRAL
BANK IN STRENGTHENING INDIAN FINANCIAL HEALTH

Indian shares were volatile in trading Friday after the central bank slashed interest rates to
mitigate the coronavirus impact on the economy, following a meeting that was brought forward
to this week. The Nifty 50 index wavered between gains and losses: It traded up 0.38% at 2:27
p.m. HK/SIN after climbing more than 4% and then dropping 1% earlier in the session. The
S&P Sensex index was down 0.7%, retracing previous advances of more than 3%.
The rupee strengthened against the dollar to around 74.69, up from levels near 74.77.

On 27 March 2020, the Reserve Bank of India (RBI) reduced the repo rate by 75 basis points
(bps). The reduction saw the repo rate reduce from 5.15% to 4.40%. Last year, on 7 February
2019, the repo rate was reduced by 25 basis points to 6.25%. The RBI reduced the repo rate on
4 April 2019 from 6.25% to 6.00%. On 6 June 2019, the repo rate was reduced by 25 bps to
5.75%. The repo rate was reduced to 5.40% on 7 August 2019 and cut again to 5.15% on 4
October 2019.

RBI reduced the reverse repo rate by 90 bps to 4.00%. Earlier, the reverse repo rate was at
4.90%. Currently, the marginal standing facility rate and the bank rate are at 4.65%. Repo rate
is the interest at which RBI lends money to commercial banks in the country. Every time this
rate reduces, it means that other banks can now borrow money from RBI at a much lower
interest rate.

“After extensive discussions, the MPC voted for a sizeable reduction in the policy repo rate
and for maintaining the accommodative stance of monetary policy, as long as necessary to
revive growth, mitigate the impact of COVID-19 while ensuring that inflation remains within
the target,” RBI Governor Shaktikanta Das said in a press briefing. Das added the current
situation is “unprecedented” and that everything hinges on “the depth of the COVID-19
outbreak, its spread and its duration.” In its policy statement, the central bank said if the
situation worsens, it would have “adverse implications for India.”

India is currently in a three-week lockdown that began this Wednesday as part of its efforts to
control the coronavirus outbreak, which causes the respiratory illness COVID-19. Finance
Minister Nirmala Sitharaman announced an economic stimulus package worth more than $22
billion on Thursday to help households that would be disproportionately affected by the
lockdown.

The RBI’s decision on Friday put it on a similar path as its peers — other central banks have
eased their monetary policies to help support their economies from the coronavirus pandemic
that has infected more than 500,000 people worldwide.

The commercial banks usually pass this benefit on to their customers by reducing the interest
rates on the loans they offer. Therefore, every time there is a cut in the repo rate, there usually
is a decline in the interest rates on loans offered by various banks. It reduces your interest rates
which means you pay a lesser amount of interest. This brings down the overall cost of your
loan. Personal loans, car loans, home loans, etc. are expected to get cheaper due to the recent
reduction in the repo rate. However, this will come into effect only if banks decide to pass on
the benefit to their customers.
Apart from benefitting general borrowers, this also is a huge boost to the industrial sector. The
reduction in the repo rate means that industries may be able to get loans at cheaper interest rates
from lenders. This is likely to result in commodities becoming cheaper due to lower interest
costs, ultimately benefitting you, the end consumer, again. That said, it remains to been seen
how soon banks will implement rate cuts on the loans they offer.
When a reduction in policy rates occurs, financial circles are usually buzzing with questions
on when the rate cut will translate into actual reductions in bank loan interest rates.

The International Monetary Fund (IMF) conducted a study on the interest rate transmission in
the country, in which, the following were deduced:
• There is a slow pass-through of policy rate changes to the interest rates offered by banks.
• Banks tend to decrease the deposit rates during rate cuts but do not reduce lending rates
right away. However, when the policy rate increases, lending rates rise quickly, but deposit
rates don’t change that fast.

Money is a bank’s raw material, absolutely vital to its day-to-day operations. In any industry,
whenever an important supplier reduces the prices of the raw materials it supplies, it triggers
price cuts downstream. Now, whether a bank passes on the benefit of the lower interest rate to
its customers or not depends on the level of competition in the market.

If any particular bank holds the monopoly power in the industry, it is not under any pressure to
pass on the lower-cost benefits to its consumers right away. This means that the transmission
of benefits arising out of RNI rate cuts may end up taking a long time.

Banks also find it difficult to reduce lending rates in the short term after a policy rate cut due
to the fixed rate of interest on deposit contracts. Also, there is competition from small savings
instruments, which makes it difficult to reduce the rates that depositors are offered. Another
issue that impedes monetary transmission is the pressure on banks to enhance equity financing
and reduce risky debt financing. This problem is particularly relevant to the current financial
landscape in India.

The level of equity needed by banks is determined by the amount of loans they have. When
they don’t immediately cut loan rates, banks stand a chance to lose some customers. The current
financial environment accepts that loss because it retards the growth of loans and the
subsequent need to improve equity. Therefore, the speed at which rate cuts pass through will
be slow if the banks are facing pressure from regulators to improve their capital buffer.

While this is a great tool to control inflation, RBI often uses this monetary policy method after
factoring the condition of the Indian economy and inflation levels to control the market
inflation and manage the liquidity of the economy. However, this process might not prove to
be effective if the banks are not ready to pass on the rate cut to the customers.

The bottom line is that apart from the lag in monetary transmission, banks are unlikely to match
RBI’s rate cuts. However, additional rate cuts and liquidity support measures are needed to
encourage banks to lower rates in the future.