Q. Who benefits when the RBI cuts rates? (The Hindu) • Money is a bank’s raw material. An RBI rate cut is like a fall in raw material prices from an important supplier. • A fall in raw material prices will quickly translate into lower product prices. • That is, following rate cuts, loan interest rates will fall. If on the other hand, the company enjoys monopoly power, it will have no pressure to pass on the lower costs. • 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. • 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. This is true for most countries and not unique to India. Monetary transmission • There are two other problems unique to the current time period and India in particular that impede monetary transmission. • The first is the pressure on banks to increase equity financing and reduce their reliance on risky debt financing. • When faced with a rate cut, decreasing deposit rates and not reducing loan rates is an easy way for banks to increase their interest margin, and hence their profits. Since profits are a form of equity, this will help them shore up their balance sheets. • 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. The amount of equity banks need is determined based on the amount of loans they make. • Thus the speed of monetary transmission, especially on the downside, will be slow if banks are not well capitalised and face pressure from regulators to increase their capital buffer. • 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. Thus, the rate of monetary transmission is captive to the government’s decision to shore up bank balance sheets.

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