Delayed monetary transmission

Banks are quick to decrease deposit rates in the face of rate cuts, but not too eager to reduce lending rates. Causes for delayed monetary transmission are:

• The largest firms in the economy raise finance in very competitive markets. If the State Bank of India does not reduce interest rates for, say, Reliance Industries Ltd. following the RBI rate cut, the company will quickly shift its borrowing either to the commercial paper market or to another bank, say ICICI. This is already happening. There is an increase in issuance of commercial paper and bonds by large corporates. Small borrowers and households, on the other hand, do not have access to alternative sources of finance and so the banks do have some monopoly power over them — at least in the short run. Hence, they do not immediately benefit from the rate cut.

• There is pressure on banks to increase equity financing and reduce their reliance on risky debt financing. This is a new focus for regulators following the financial crisis in the U.S. which highlighted the dangers of an over-reliance on debt financing. By not aggressively cutting loan rates, banks may lose some of their best customers. In the current environment, Indian banks welcome that because it slows loan growth and the need to raise more equity. 

• Banks are not well capitalised and face pressure from regulators to increase their capital buffer. 
• Government's ownership of large banks. A government bank’s ability to increase equity is dependent on the government’s disinvestment programme and its decision to infuse equity in the banks. Since banks do not control the decision to raise equity, they move the levers under their control, which is to increase interest margin and slow loan growth.