After holding the repo rate — the rate at which banks borrow short-term funds from the RBI — for a year, the central bank has cut the policy rate by 50 basis points since January this year. But banks, surprisingly, have not followed suit in lowering the lending rates. 

While banks have always been reluctant to pass on the rate actions of the RBI to customers, the tardiness this time around is mainly due to a seemingly tight liquidity situation.

Banks have been lowering their rates on deposits across tenures in the last six months. This should have given them enough headroom to lower the lending rates. Banks decide their base rates — to which all lending rates are pegged — based on cost of funds, administrative costs and profitability. But banks continue to drag their feet.

One of the main reasons for this has been slow credit offtake. Bank credit growth has slipped to 10 per cent levels and this has impacted banks’ margins. In a bid to keep their margins intact, banks have been putting off lending rate cuts.

But aside from this, banks, it appears, also face an unusual liquidity situation. They used to source funds for their short-term needs from the RBI at a fixed repo rate. But in October 2013, the RBI decided to move to the term repo mechanism as it did not want to extend unlimited funds to banks at a fixed rate.

Term repos

The RBI capped the amount they can borrow under the fixed repo window to 0.25 per cent of deposits. And, the shortfall could be made good by term repo auctions (for seven- and 14-day periods) held by it. Banks can now source overnight funds from this auction by bidding rates at which they would like to borrow.

The RBI’s intention to move away from the fixed repo rate was to ensure quicker transmission on policy rates. But by tweaking the amount of money it makes available through term repos, the RBI is keeping a tight leash on short-term rates in the economy.

According to market players, the RBI is, in effect, micro-managing liquidity. Many banks still offer about 8.25 per cent on deposits of 90- or 120-day tenures.

This is almost one percentage point higher than the policy repo rate at 7.5 per cent.

In the past, the spread between the repo rate and the yield on the 90-day Treasury bill (benchmark instrument for short-term borrowings) has been in the range of 30-40 basis points.

The spread is now close to one percentage point, indicating that banks are reluctant to cut deposit rates in a meaningful manner. Banks continue to carry excess investments in Government securities (3-5 per cent higher) than the mandated Statutory Liquidity Ratio (SLR) requirement. But this is to ensure compliance with Basel III norms on liquidity.

Banks are thus, not borrowing aggressively against their SLR securities. Instead, they continue to depend on deposits.

This means that they cannot lower the rates on deposits substantially. The RBI will have to follow rate cuts with ample liquidity to ensure transmission.

Banks can only cut lending rates if there is an accumulated reduction in deposit rates. 

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