Monetary Transmission

In News: Banks with higher capital ratios transmit monetary policy actions more smoothly than banks with lower capital base according to recent study by RBI .

Concept

The RBI study attempts to understand the link between bank capital and monetary transmission by looking at the relationship between bank capital and loan growth/cost of funds.
It states that for each one percentage point increase in CRAR, there is a 7.8 percentage points rise in loan growth rate. On the contrary, one percentage point increase in GNPA ratio reduces the loan growth rate by 0.9 percentage points.
In effect, while rise in capital ratio helps in better monetary policy transmission, a significant amount of stressed assets could limit credit supply.

What is monetary policy transmission ?

Repo rate is the interest rate that the RBI charges the banks when it lends them money.
The banks’ lending rate is the interest rates that banks charge from customers when they take a loan.
By cutting the repo rate, the RBI has been sending a signal to the rest of the banking system that the lending rates in the system should come down.
This process of repo rate cuts leading to interest rate cuts across the banking system is called “monetary policy transmission”

What was RBI’s response?

In response to the sluggish transmission, the RBI decided to cut the repo rate by another 25 basis points in October 2019.
It urged banks to link their lending rates to the repo rate.
Yet, for the most part, the banking system has ignored the signalling.
Only some banks have reduced lending rates on new loans by 10 basis points.
Indeed, even though it is counter-intuitive, interest rates on existing loans (not new loans) have actually.

How does lowering interest rates help?

A lower interest rate regime is expected to help in resolving both of these.
Consumption
- The prevalent argument is that if banks reduce their lending rates, they would also have to reduce their deposit rates.
- Reducing deposit rates will, in turn, incentivise people to save less and spend more i.e. increased consumption.
- [Deposit rate is the interest rate banks pay when consumers park their money in a savings bank deposit or a fixed deposit.]
Investment
- The low investment by businesses is partly because they have unsold inventories because people are not buying as much.
- But, part of the reason is also that the interest rate charged on loans is quite high.
- If interest rates are lowered, more businesses are likely to be enthused to borrow new loans for investment.
- This is particularly fitting as the government has recently cut corporate tax rates in the hope to boost investment and corporate sector’s profitability.
So, given that overall retail inflation too has been well within the comfort zone of 4%, the RBI’s decision to cut repo rates was a justified move.