Banks cut deposit rates despite RBI's status quo: Is monetary policy still relevant?

Several banks have started lowering their deposit rates even though the RBI did not change the policy rate on December 2nd. Does this mean that banks have come of age and are going to take independent decisions that are not necessarily in alignment with the RBI’s moves?

If this were should then the RBI be pleased that it has gotten banks to lower rates even though it has held on to the inflation targeting module? Or does this pose a policy challenge for the central bank especially if this becomes a habit?

Ideally interest rates charged by banks should be market determined. This was the main idea when the RBI moved away from the fixed rates regime and transitioned from MLR to PLR to base rate regimes. While policy was to indicate the direction, banks were not obliged to follow suit and could do so based on their own balance sheet and income statements.

Banks so far have gone along with the RBI; and even though one could understand companies asking the RBI to lower interest rates, the same voice from banks sounded out of place. This was because when the RBI changed the repo rate, which is the tool being used today, only 1% of the NDTL gets affected, which broadly speaking was Rs 80,000 crore that is lent through the repo windows (overnight and term).

Even a 1% change in rates would have changed the cost for banks by Rs 800 crore, which is very small given a total income of around Rs 9.5 lakh crore. But this became a practice. In fact, at times even when the RBI changed rates, banks did not follow causing the regulator to lament on the slow transmission mechanism of monetary policy.

Why have things changed suddenly now? Banks appear to be simply responding to market forces as they have been pushed to a corner. Bank deposits growth has been higher than that of both credit and investments. For instance, for the period April-November 14, 2014, bank deposits have increased by Rs 5.5 lakh crore while credit has increased by Rs 2.6 lakh crore and investments by around Rs 2 lakh crore.

The surplus cash in the system appears to be around Rs 90,000 crore. In such a situation, banks do have a challenge in controlling costs as deposits cannot be refused. One way of slowing down their flow is to lower deposit rates so as to make them relatively less attractive.

Will this translate to lower lending rates? One is not sure of how the banks perceive risk today on the lending side. So far, banks have been lending more to the retail segment where there are fewer NPA cases. Bank lending to industry and services is only marginally up. If banks believe that the economy has turned around, then the risk premium attached to lending in times of an economic slowdown will reverse and they could be lowering their lending rate.

However, again it would be interesting to see if banks differentiate between short term and long term rates. Short term rates could move down, but for long term rates, the actual translation of government action on infra projects has to look positive.

Will banks continue to work independently? This is unlikely because in general they would be following the guidance from the RBI and the present phase is one which is also premised on the RBI lowering rates in February as it was indicated indirectly in the policy. This provided the spirit which combined with the reality of surplus liquidity did prompt them to lower rates.

Ideally one would have liked the banks to lower even lending rates, as they do matter more at the end of the day. But this will definitely be an indication to the RBI that banks would also be looking at the market conditions before taking decisions on interest rates.

With inflation already down, and being located on the cost side, the RBI would not really mind this development as through an apparently innocuous statement on possible future rate action, they have been able to move banks to lower rates. It can also be surmised that banks may review this move once credit starts picking up in the coming months.

At present there is an anomaly in the market where there is surplus liquidity and GSec yields are going down quite rapidly. The RBI is trying to mop up surplus liquidity through reverse repo auctions and OMO sales. The CP and CD rates have also moved down from levels of above 9%.

But the policy rates have remained high on account of inflation being a concern. Banks have hence decided to lower the deposit rates to begin with to stop the flow of funds. Today, deposits of 1 year yield 8-9% and GSec yields have dropped with the 10-years paper being less than 8%. Therefore, this reduction does lead to control of costs for the banks.

What about monetary policy? Is it relevant? It surely is as it sets the ground rules and as we transition to the term repo market, rates will feed into the deposit rates structure and hence improve transmission. But the RBI may also have to consider the market situation when pursuing its policy as banks have taken a unilateral call today. As long as lending rates are tied to policy, it would not be a concern.

However, in a situation, where inflation rates are high and policy rates following suit, if banks lend at lower rates, then monetary policy perforce has to become more aggressive. This will be a consideration in future for the RBI if such decisions are taken more often by banks which could go against its own thinking.

The author is chief economist, CARE Ratings. Views are personal