After 3rd repo rate cut, will banks lower lending rates?

1) How do interest rates of banks look since the beginning of 2019?

Two different interest rates need to be considered. First, the rate at which banks have been borrowing and second, the rate at which they have been lending. The weighted average interest rate on term deposits of banks was 6.91% in January. By April, it had fallen by six basis points to 6.85%. One basis point is equal to 0.01. During the same period, the weighted average lending rate of banks has risen by four basis points from 10.38% to 10.42%. What this tells us is that in terms of outstanding loans of banks, the interest rates of both borrowing and lending have barely moved.

2) Why is that the case with banks?

Since January, the credit to deposit ratio of banks has been 77% or more, except on one occasion—the fortnight ending 10 May—when it stood at 76.9%. Banks need to maintain a cash reserve ratio of 4% with the central bank. They also need to maintain a statutory liquidity ratio of 19% by investing in approved government securities. After adjusting for cash reserve ratio and statutory liquidity ratio, it is clear that banks are lending out almost all the deposits they have. Hence, they are not in a position to reduce interest rates on their deposits as they need fresh deposits to keep funding their loans.

3) What does this mean?

With banks not being in a position to cut interest rates on their deposits, the question of reducing interest rates on their lending does not arise. Deposit growth stood at 15.3% in 2016-17 due to demonetization. It fell to a more than five-decade low of 6.2% in 2017-18. Deposits gathered in 2016-17 helped banks for a while. After that, the deposit growth slowdown started to hurt and that has primarily led to a situation where banks have not been able to cut down their borrowing and lending rates despite RBI’s repo rate cuts. To enable banks to cut rates, deposits need to grow faster, so as to bring down the credit-deposit ratio.

4) How has deposit growth fared in the recent past?

In 2019, deposit growth of banks has been close to 10%, much better than in 2018. The annual deposit growth needs to increase a little more and reach around 12-13% before banks feel confident about cutting interest rates. In 2017-18, interest rates on deposits had crashed in the aftermath of demonetization, leading investors to look at other avenues.

5) Are lending rates likely to be reduced?

One impact of the crisis at non-banks is that more money will now move into banks. This should help in faster deposit growth. But this will take time. Banks need to hold on to the interest rates on their deposits for the next few months, so that their deposit growth is robust enough to get the credit-deposit ratio below 75% and help them cut interest rates after that.

Vivek Kaul is an economist and the author of the Easy Money trilogy.