Why banks may not cut lending rates soon enough

Axis Bank became the first bank to slash deposit rates after the RBI cut its key policy rate by 25 bps on March 4. The cut in deposit rate by India's third-largest bank is not what RBI had in mind—

the central bank is expecting banks to lower lending rates to pass on the benefits of lower rates to consumers.

Indian banks have been reluctant to cut lending rates despite the central bank providing two unexpected rate cuts of 25 bps each in January and March and data suggest that the consumers would have to wait a little longer for banks to cut lending rates. The RBI has been critical of the banks as it wants the credit cycle in the economy to improve which can only be done once banks start transmitting rate cuts.   

A recent report by the International Monetary Fund (IMF) explaining the transmission of monetary mechanism explains why rates won't fall soon enough. The report follows a two-step process with repo rate movements being translated into call money rate adjustments and then finally having an impact on lending rates and deposit rates. The study points out that while the first stage of transmission is quick enough, it is the second stage that takes time. 

But it is not just the transmission mechanism that is weighing down on rates in India. There has been reluctance on banks’ part to lend as the non-performing assets in the industry have been rising. According to RBI data, gross NPAs of the PSU banks were Rs 2,60,531 crore as on December 2014. Banks’ profitability has been hurt because of the rise in NPAs and banks want to take advantage of the cut till the time they can cover at least some losses on the NPAs. 

On the other hand, the government has asked banks to comply with Basel III standards where banks are required to cover 15 per cent of the restructured loans instead of 5 per cent. 

"The need to preserve margins and prevent further hurt to asset quality will thereby deter aggressive reduction in lending rates." wrote economists at DBS Bank in a research note.

"Given this backdrop and tepid demand conditions, credit growth is unlikely to deviate from 10-13 per cent pace this year, down from 20 per cent in 2011-12. In terms of rate outlook, we expect another 25 basis point cut by June and pause thereafter, set against the likelihood of US rate hikes in the second half of 2015, a narrowing output gap and our in-house expectations for gradual Indian rupee depreciation in the quarters ahead," they added. 

The next policy meeting of the RBI is on April 7; though the bank is not expected to cut rates further, there are expectations that governor Raghuram Rajan would chalk out the rate path for the next few months given that Fed rate delay has given the RBI more time.

(Edited by Joby Puthuparampil Johnson)

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