In response to the cumulative hike in repo rate by 250 bps during May 2022 to October 2023, the SCBs revised their repo-linked benchmark rates upwards by the same magnitude
Yuvraj Kashyap, Avnish Kumar, Anand Prakash and Shubhangi Latey;
Monetary Policy Department, RBI;
Under guidance of Muneesh Kapur,
Executive Director, RBI
Mumbai, November 20, 2023: The Reserve Bank has released the November 2023 issue of its monthly Bulletin. Article in the RBI Bulletin November 2023 titled ‘Monetary Policy Transmission in India: Recent Dynamics’ reviews recent dynamics of monetary policy transmission to lending and deposit rates of banks. Transmission to Banks’ Lending and Deposit Rates Lending and deposit rates of scheduled commercial banks (SCBs) have exhibited co-movement with the policy repo rate (Chart 1). The extent and speed of transmission have varied across monetary policy cycles and benchmark regimes, along with an asymmetry in the transmission to deposit and lending rates.
Lending Rates
The transmission to lending rates improved significantly during the easing phase, i.e., February 2019 to March 2022. Almost complete transmission to lending rates was witnessed, albeit over time, and this phase coincided with the introduction of the external benchmark regime in October 2019. The weighted average lending rate (WALR) of SCBs on fresh rupee loans touched a decadal low in April 2022. The lending rates have started increasing since May 2022 with the hike in the policy repo rate. The EBLR system, the normalisation of surplus liquidity and robust credit growth aided transmission in the current tightening phase. In response to the cumulative hike in repo rate by 250 bps during May 2022 to October 2023, the SCBs revised their repo-linked benchmark rates upwards by the same magnitude. The 1-year median marginal cost of funds-based lending rate (MCLR) rose by a relatively lower magnitude of 152 bps, reflecting the trends in banks’ cost of borrowings. Consequently, the WALR on fresh rupee loans rose by 187 bps, while that on outstanding loans rose by 111 bps during May 2022 to September 2023. The increase in the share of outstanding floating rate loans linked to external benchmark and a quicker reset of such loans at higher benchmark rates have facilitated the transmission to WALR on outstanding loans in the current tightening period. Among various external benchmarks, most banks have chosen the policy repo rate as their benchmark for the pricing of loans (Chart 3a). The share of loans in the above 8 per cent interest rate range has increased (Chart 3b). At bank group level, the increase in the WALRs on fresh rupee loans was higher in the case of public sector banks (PSBs) relative to private banks (PvBs) during the period May 2022 to September 2023. However, the transmission to WALR on outstanding loans was relatively more for PvBs as compared to PSBs. The proportion of outstanding floating rate loans of the PvBs linked to external benchmark rates is higher than that of the PSBs, and this could have facilitated a greater pass-through to lending rates of PvBs. The transmission to lending and deposit rates was the maximum in the case of foreign banks, reflecting the preponderance of their loans being EBLR-linked on the lending side and a higher share of low cost and lower duration wholesale deposits on the liabilities side, which facilitate a faster adjustment in interest rates. The WALRs on fresh as well as outstanding rupee loans to major sectors increased during May 2022 to September 2023. The pass-through has been uneven across sectors reflecting risk profiles and the varied nature of loans extended in each sector.
Transmission during Tightening Episodes
The pass-through of policy rate changes to lending rates in the tightening cycles over the past decade has varied sizeably, depending upon factors such as the duration of the tightening cycle, the speed of the rate hikes, and the prevailing liquidity conditions apart from episode-specific events. During the taper tantrum tightening episode (July 2013 to December 2014), the RBI raised the marginal standing facility (MSF) rate, which became the de facto policy rate, and undertook liquidity tightening measures including limiting banks’ access to LAF and increase in daily CRR balance maintenance requirement even as the repo rate was left unchanged. Once normalcy was restored in the financial markets, the MSF rate was reduced while the repo rate was increased to contain the inflationary pressures (RBI, 2014). However, amidst surplus liquidity in the system, banks started reducing their lending rates even as the repo rate was unchanged, impeding the degree of transmission in this cycle (Chart 5a). During the June 2018 to January 2019 tightening episode, SCBs increased their lending rate on fresh loans by 55 bps in response to 50 bps change in the repo rate. The tightening cycle that started in May 2022 has seen a higher magnitude of increase in the policy repo rate relative to the earlier cycles (Chart 5c). The increase in policy repo rate is still working its way through the system in the current tightening cycle (Das, 2023). Banks have reportedly reduced spreads charged on new loans over the past few months, thereby moderating the extent of transmission to actual lending rates on new loans.
Deposit Rates
On the deposit side, the surplus liquidity conditions coupled with weak credit demand prompted banks to reduce their term deposit rates in the previous easing cycle (2019-22). In the current tightening cycle, with the sustained robust credit demand amidst tepid growth in deposits in the initial phase and moderation in surplus liquidity in the banking system, banks increased their term deposit rates significantly to attract fresh deposits During May 2022 to September 2023, the weighted average domestic term deposit rate (WADTDR) on fresh deposits (bulk and retail combined) increased by 229 bps as against the increase of 250 bps in the repo rate. Banks raised their bulk term deposit rates more than retail term deposit rates in the initial phase of the tightening cycle. The increase in retail deposit rates outpaced increase in bulk deposit rates beginning second half of FY 2022-233 . Overall, the WADTDR on fresh retail deposits increased by 164 bps as compared to 269 bps in case of fresh bulk deposits during May 2022 to September 2023. The transmission to WADTDR on outstanding deposits was lower at 166 bps over the same period, reflecting the longer maturity profile of term deposits contracted at fixed rates . The EBLR system hastened the adjustments in deposit rates during the 2020-22 easing cycle, as banks were incentivised to reduce their term as well as savings deposit rates to protect their net interest margins (NIMs) in an environment of falling lending rates. On the other hand, during the tightening cycle, the pace of increase in deposit rates (term deposits and savings account deposits taken together) has lagged the pace of increase in lending rates so far. While the increase in term deposit rates in the current tightening cycle has exceeded that in lending rates, the savings deposit rates of banks – which are a third of total deposits – have remained almost unchanged. This has moderated the increase in the banks’ overall cost of funds. Accordingly, higher NIMs have been observed during the current tightening phase so far.
Recent International Experience
Multi-decadal high inflation has been a global phenomenon across the world since the beginning of 2022. In response, central banks embarked on the path of monetary tightening, which has been the most synchronised tightening episode in the last five decades (BIS, 2022). Central banks raised policy rates at about twice their historical pace in the 2022-23 cycle (Chart 8). In response to monetary policy tightening, banks in many jurisdictions have raised their lending rates significantly. The pass-through has varied across countries, reflecting inter alia different financial structures. In Euro area, where banks constitute an important segment of financial markets, transmission to term deposit rates has been significant while households’ sight deposits witnessed limited pass-through (François Villeroy de Galhau, 2023).
Empirical Analysis
In this section, an attempt has been made to empirically estimate the drivers of the pass-through of policy rate changes to lending and deposit rates of SCBs in a panel framework using generalised method of moments (GMM) estimator approach. Following Gambacorta (2008), the role of macroeconomic as well as bank specific factors in shaping monetary transmission is analysed
Results
At the outset, bin scatter plots6 have been drawn for a preliminary non-parametric analysis of the relationship between the dependent and the explanatory variables. Scatter plots show that the WALR on fresh rupee loans is positively correlated with the repo rate, while liquidity, CASA share and GNPA are negatively correlated during the EBLR period as well as for the whole sample period, i.e., FIT period. CRAR is positively correlated during the EBLR period, while there is a weak correlation in the whole sample period. The correlation between incremental CD ratio and lending rate is ambiguous for the whole sample period.
Three models have been estimated with model I covering the entire sample period, i.e., FIT period, while model II specifically deals with the impact on transmission during the tightening cycles in the whole sample period. Model III covers the EBLR sub-period. The results suggest that a 100 bps increase in the policy repo rate has a contemporaneous significant positive impact of 20-25 bps on the lending rates of banks across the models and the long-run impact is higher at 82 bps during the EBLR period, and 69 bps during the overall period (63 bps in model II). Systemic liquidity in the banking system and the share of CASA deposits in total deposits have the expected negative and significant impact on lending rates. It may be mentioned that the share of CASA deposits in total deposits increased from 41.2 per cent in September 2019 to 44.8 per cent in March 2022. An increase in credit/deposit ratio has positive impact on lending rates and thus expected to strengthen the pass-through to lending rates during the tightening phase. While capital adequacy ratio has a positive and significant impact on lending rates over the full sample period, the asset quality of banks has an insignificant impact on the lending rates. To assess the asymmetric impact of monetary policy, an interaction dummy (T_Dumt*Repot) that captures the differential pass-through to lending rates during the tightening cycles vis-à-vis easing cycles is introduced. The coefficient of the interaction dummy is positive and significant (Model II), implying that the pass-through to lending rates is higher during the tightening cycle. In the case of deposit rates, as noted earlier, the analysis pertains to a shorter period 2020:Q1 to 2022:Q4. The results indicate that a 100 bps change in the policy repo rate pushes term deposit rates by around 70 bps contemporaneously. The surplus liquidity and the credit/deposit ratio have the expected negative and positive signs, respectively. High investment ratio dampens transmission to deposit rates as banks can meet higher credit demand by drawing down on their excess investments rather than mobilising fresh deposits. Bank size is found to have a negative impact on deposit rates suggesting big banks offer lower rates on term deposits. IV. Conclusion This article has attempted to analyse recent dynamics in monetary transmission to banks’ lending and deposit rates. The transmission to banks’ interest rates has improved in the recent period, facilitated by the introduction of the EBLR system. Large surplus liquidity and subdued credit demand aided transmission during the pandemicphase of the easing cycle, while the calibrated normalisation of surplus liquidity and robust credit growth strengthened transmission during the current tightening phase. The transmission to term deposit rates has been robust while savings deposit rates have exhibited rigidity. An empirical bank-level analysis in a panel framework indicates that surplus liquidity in the banking system and a higher share of CASA deposits in total deposits has a negative and significant impact on lending rates, while higher capital adequacy ratio has a positive and significant impact on lending rates. High credit/deposit ratio strengthens the transmission to deposit and lending rates while excess SLR lowers the pass-through to deposit rates. The pass-through to lending rates is found to be higher during the tightening cycle. The extent of transmission has improved after the introduction of EBLR system in October 2019. With the MCLR-linked loans still a sizeable part of the lending portfolio, the transmission of the policy rate actions to deposit and lending rates is ongoing at the current juncture.
