Chidambaram rushes to do what Subbarao couldn’t

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What Reserve Bank of India (RBI) governor D. Subbarao could not do through a series of rate cuts, India’s finance minister P. Chidambaram now wants to achieve through a gentle nudge. Bank of India announced a cut in its base rate or the minimum lending rate on Wednesday by 25 basis points (bps). Other banks, barring the nation’s largest lender State Bank of India, are expected to follow suit. One basis point is one-hundredth of a percentage point.
After the cut, Bank of India’s base rate will be 10%. SBI’s base rate is 9.7%.
Bank of India cut its loan rate after Chidambaram asked state-run banks to lower their minimum lending rate and disburse more loans to stimulate growth in Asia’s third-largest economy.
Subbarao has been cutting rates with the same intention, but banks have not been listening to the regulator.
Since January, RBI has cut its policy rate by 75 bps, but banks have cut their loan rates only by about one-third of that.
In fiscal 2013, RBI had cut its policy rate by 100 bps, but the average loan rate reduction by banks’ was 36 bps. The reason? Banks could cut their deposit rates by just 11 bps points. If they cannot bring down their deposit rates, how will they pare their loan rates?
The logic is flawless, but this makes it pretty clear that RBI has failed in monetary transmission. And that the gap between the loan market and bond market in India is getting wider. When RBI cuts its policy rate, only the bond market reacts; the loan market remains insulated. A look at how the 10-year benchmark bond yield has moved in the past one year and the trajectory of banks’ loan rate proves that. The government is the biggest beneficiary of policy rate cuts and companies hardly get any benefit.
Banks have been clamouring for a cut in their cash reserve ratio (CRR) or the portion of deposits that they keep with RBI. They say this will help them cut their loan rates. Their logic is that they do not earn any interest on CRR and once RBI brings it down, the money thus get freed will earn interest for them and that earning can offset the impact of a rate cut.
If we accept that logic, there is hardly any possibility of companies seeing loan rates going down. The CRR is currently pegged at 4%. Theoretically it can go to zero, but no prudent central banker will do that. One might see a 100 bps cut in CRR over a period of time.
Does that mean that the banks will continue to charge high rates to corporate and individual borrowers? The answer is yes. Companies will have to pay for the inefficiency of the banking system, the inability of their peers to pay back bank loans, and RBI’s failure in monetary transmission—and not necessarily in this order.
In October 2011, when RBI freed the rates of savings bank account, the last bastion of administered rate in Indian banking system, expectations were high that banks would respond to this cry of freedom, but they decided to play safe. Barring a handful of new private banks—Yes Bank Ltd, Kotak Mahindra Bank Ltd and IndusInd Bank Ltd—no bank tinkered with the savings rate.
These three raised their savings bank rate, while others continue to pay 4%. One can appreciate the fact that they did not want to wage a rate war, but what prevents them from cutting the savings bank rate now when inflation is low?
For the record, in October 2011, wholesale inflation was 9.87% and the non-food, non-oil, manufacturing inflation or the so-called core inflation was 8.13%. In May, wholesale inflation dropped to 4.7% and core inflation 2.43%. If the savings bank rate continues to remain at the October 2011 level, how can we expect to see monetary transmission?
Did I hear someone say lazy banking?
Banks cannot bring down their loan rates because they all believe in status quo. And they are grappling with bad assets. Bad assets are a double-edged sword. Banks do not earn on such assets and on top of that they need to set aside money for them. After doing that, they are not left with anything that can be passed on to the borrowers.
Even if Subbarao brings down the policy rate to zero, our banks will not be able to cut their loan rates substantially. The regulator has failed to push them. Let’s see whether their majority owner succeeds.

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