The RBI's stance on interest rates has come under discussion in the recent past. Banks have argued for a rate cut to enable them to lower interest rates. In the same breath, some have also debated in favour of a CRR cut on the grounds that this will enable them to lower rates. The FM has been asking the RBI to take action, while the RBI has been selective this year in terms of lowering the repo rate (April) and the CRR (February, March, September and October). The RBI evidently sees interest rates and inflation more from a macro view and implicitly looks at real interest rates. But, how do banks react to rate cuts? Are they really sensitive to rate changes or are they just asking for more?
As a corollary, how do liquidity and G-Sec yields respond? A repo rate change alters the base rate, directly depending on the bank's borrowing from this window. The deposit rates movement is quite discretionary as the bank has a choice to pass on the benefit or simply add to the bottom line. In case of CRR, banks have to perceive it as an increase in the supply of funds to be able to lower rates. But if they get invested in G-Secs, then CRR action may not really matter.
Let us look at the first year — October 2010 to October 2011. The repo rate was increased by 250 bps during this period. Banks increased the deposit rate (for one year as reported by the WSS-RBI), by 125 bps, while the base rate of banks increased by 233 bps. Quite clearly, any rise in interest rates gets reflected less in deposit rates, while base rates increase by almost the same range. G-Sec yields rose by 77 bps, which is the market perception on risk-free bonds, indicating a premium of around minimum 150 bps on commercial lending.
The repo rate was lowered in April by 50 bps, while changes in CRR were invoked prior to this move and subsequently in September. On a partial equilibrium analysis basis, the base rate moved down by around 18 bps by October, while deposit rate moved down by 25 bps. These changes, however, may not be attributed to just the repo rate cut as the CRR was also reduced periodically. Looking at CRR reductions now from February onwards — there were two successive cuts in February and March. The deposit rates did not change till October after the September relaxation in CRR, while the lending rate went down gradually by 17 bps till September, before another CRR cut was invoked.
Therefore, CRR cuts did not change the structure of interest rates significantly, though base rates were relatively more responsive. Banks have hence held on to deposit rates in this situation. Curiously, liquidity, too, was not really affected on all the three occasions, as the amount released got absorbed in the system almost immediately.
Lending from RBI remained high in February and March (Rs 1,40,000-1,50,000 a day) and was at lower, though still high levels till June (Rs 90,000-1,00,000). The notional benchmark of 1% of NDTL being the ideal amount traded on this window was breached.
The conclusion is that CRR cuts do not really matter much in terms of impact on liquidity or interest rates, especially, when there is a large liquidity deficit in the system. The G-Sec market has been more responsive with the 10-year yield moving downwards by 45 bps since April, when repo and CRR cuts were brought in. The market hence is more alert to policy changes and reacts well as per economic theory. Therefore, what has been observed is that banks do react to repo rate hikes with alacrity and raise deposit rates by less than the base rates, which improves profit margins. But, when CRR is reduced or repo rate is cut, there is some level of intransigency in rates.
Also, CRR reduction certainly does not ease liquidity and is more of a signaling device, which is picked up, albeit, quite mildly by banks. The G-Sec market is more robust in comparison. Hence, even if one would like to throw the onus on RBI for getting the economy started through rate cuts, the reaction of banks is not certain, because somewhere, they do, even though they may not admit it, look at the true economic cost of capital when deciding on their interest rates. Relentlessly asking the RBI to lower rates is one part of the story, but the reaction from the system is certainly more interesting.
As a corollary, how do liquidity and G-Sec yields respond? A repo rate change alters the base rate, directly depending on the bank's borrowing from this window. The deposit rates movement is quite discretionary as the bank has a choice to pass on the benefit or simply add to the bottom line. In case of CRR, banks have to perceive it as an increase in the supply of funds to be able to lower rates. But if they get invested in G-Secs, then CRR action may not really matter.
Let us look at the first year — October 2010 to October 2011. The repo rate was increased by 250 bps during this period. Banks increased the deposit rate (for one year as reported by the WSS-RBI), by 125 bps, while the base rate of banks increased by 233 bps. Quite clearly, any rise in interest rates gets reflected less in deposit rates, while base rates increase by almost the same range. G-Sec yields rose by 77 bps, which is the market perception on risk-free bonds, indicating a premium of around minimum 150 bps on commercial lending.
The repo rate was lowered in April by 50 bps, while changes in CRR were invoked prior to this move and subsequently in September. On a partial equilibrium analysis basis, the base rate moved down by around 18 bps by October, while deposit rate moved down by 25 bps. These changes, however, may not be attributed to just the repo rate cut as the CRR was also reduced periodically. Looking at CRR reductions now from February onwards — there were two successive cuts in February and March. The deposit rates did not change till October after the September relaxation in CRR, while the lending rate went down gradually by 17 bps till September, before another CRR cut was invoked.
Therefore, CRR cuts did not change the structure of interest rates significantly, though base rates were relatively more responsive. Banks have hence held on to deposit rates in this situation. Curiously, liquidity, too, was not really affected on all the three occasions, as the amount released got absorbed in the system almost immediately.
Lending from RBI remained high in February and March (Rs 1,40,000-1,50,000 a day) and was at lower, though still high levels till June (Rs 90,000-1,00,000). The notional benchmark of 1% of NDTL being the ideal amount traded on this window was breached.
The conclusion is that CRR cuts do not really matter much in terms of impact on liquidity or interest rates, especially, when there is a large liquidity deficit in the system. The G-Sec market has been more responsive with the 10-year yield moving downwards by 45 bps since April, when repo and CRR cuts were brought in. The market hence is more alert to policy changes and reacts well as per economic theory. Therefore, what has been observed is that banks do react to repo rate hikes with alacrity and raise deposit rates by less than the base rates, which improves profit margins. But, when CRR is reduced or repo rate is cut, there is some level of intransigency in rates.
Also, CRR reduction certainly does not ease liquidity and is more of a signaling device, which is picked up, albeit, quite mildly by banks. The G-Sec market is more robust in comparison. Hence, even if one would like to throw the onus on RBI for getting the economy started through rate cuts, the reaction of banks is not certain, because somewhere, they do, even though they may not admit it, look at the true economic cost of capital when deciding on their interest rates. Relentlessly asking the RBI to lower rates is one part of the story, but the reaction from the system is certainly more interesting.
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