Opinion
RBI cut repo rate in Feb. Why did it take so long for banks to reduce interest rates?
Summary
- Interest rates are likely to ease more from April onwards, with the onset of the new fiscal year.
The Reserve Bank of India (RBI) initiated the much-expected rate-cut cycle in February. The repo rate was cut from 6.5% to 6.25% on 7 February. A rate cut leads to an easing of interest rates on loans. However, loan rates have just started easing, after a rather longer transmission period.
Rate cut transmission
Let us look at how transmission of rate action from the RBI percolates to the ground. The repo rate is the rate at which the RBI lends money to banks if required, one day at a time. When the RBI wants to increase or decrease interest rates in the economy, they increase or decrease the repo rate. Hence, this is the signal rate to the system for adjusting interest rates accordingly.
Immediate transmission of repo rate changes happens to the inter-bank call money market. The reason is that the repo rate is the pivot on which money market rates revolve. Changes to money market yields, i.e., traded levels of treasury bills or bank CDs, happen fast as a ripple effect of changes in the call money market. Traded yield levels of government bonds change fast, rather in anticipation of the RBI rate action, even before the rate action.
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Transmission to banking deposit and lending rates is a function of the type of loan. In floating-rate loans, the RBI has allowed three benchmarks for banks to choose. One is the repo rate, one is the three-month treasury bill yield, and the other is the six-month treasury bill yield. These are called external benchmarks, as they cannot be controlled or influenced by any one bank.
Fixed-rate loans are benchmarked to marginal cost-based lending rates (MCLR). The MCLR also is reviewed and revised, but it takes time. Only when the MCLR is changed, your loan rate may change, depending on the terms and conditions of the contract.
Current situation
In the current context, banking system liquidity is tight. Today, the RBI is funding banks through repos of various tenures. The RBI has undertaken multiple measures to improve banking system liquidity. Things will improve gradually from April onwards, with the onset of the new fiscal year.
The implication is, liquidity being tight currently, banks require funds. In this situation, banks are not really in a position to ease interest rates, as they require more deposits. The MCLR, being a function of the cost of deposits, has not eased. Consequently, interest rates on fixed-rate loans are not easing yet.
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In the secondary money market, yields on instruments like treasury bills have not eased since 7 February 2025, even after the repo rate cut. When banking system liquidity is surplus, it leads to higher demand (lower yields) for treasury bills, and vice versa. Net-net, banking system liquidity tightness is preventing the passage of the 7 February rate cut. Floating-rate loans benchmarked to repo rate have eased, but the ones linked to T-Bill yields are yet to.
What now?
Things will improve from April onwards. The rationale is two-fold. One, the second rate cut of this cycle is expected on 9 April 2025, as inflation is easing. Another rate cut would bring the pivot (repo rate) further down. Two, banking system liquidity would move to surplus.
With the onset of the new fiscal year, the government will start spending as per the Union budget presented on 1 February. Consequently, funds in the government’s account with the RBI will flow to the banking system. This would contribute to liquidity tightness moving towards a surplus zone. The RBI action taken so far to ease the liquidity tightness will become more visible in terms of impact.
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With the improvement in banking system liquidity, money market yields will ease. Floating-rate loans benchmarked to T-Bill yields will ease. Banks, with liquidity at their disposal, will be in a position to cut deposit rates in accordance with the RBI rate cut signal. With easing deposit rates, the MCLR also should ease.
The passage of the RBI rate action is not just your or my concern; the RBI also shares it. Due to certain non-recurring events, liquidity remains tight, e.g. the RBI intervention in the forex market to support the rupee and equity offloading by foreign institutional investors. The extent of the RBI intervention in the forex market is lower now than in October-December 2024. As banking system liquidity becomes surplus from deficit, and hopefully the RBI announces further rate cut(s), we will see lower loan rates in the new fiscal year.
Joydeep Sen is a corporate trainer (financial markets) and an author.
