“Why should a cut in Repo rate transmit to bank lending rates?” is NOT a stupid question.

Governor Rajan cut the Repo rate by 50 bps in the Monetary Policy Review on Sep 29^th, surprising markets that were expecting a 25bps cut. The Governor wants maximum transmission of the rate cut by banks (meaning he wants the cut in Repo rate to translate into an almost equivalent cut in the banks’ “base rates” – these are the benchmark rates on the basis of which banks lend money to borrowers). Note: in CY2015, the RBI has cut the Repo rate by 125 bps till date (from 8.00% to 6.75%), while top banks have cut their base rates by 60-70bps. So while transmission has happened, it has been incomplete.

Here’s why a cut in Repo rate doesn’t easily translate into lower bank base rates/ lending rates:

1) Repo funds form a very small percentage (less than or =1%) of the total deposits of banks – so little direct impact on cost of funds from a cut in Repo rate.

The banking sector can borrow upto 1% of its net demand and time liabilities (i.e. total deposits) from the RBI’s LAF (Repo) window. Repo funds are used by banks mainly to meet any short-term liquidity requirements (maintaining CRR for example). For bank base rates and consequently lending rates to go down, the average cost of deposits (the average interest rate that banks pay to their depositors) must fall.  Given that Repo funds form less 1% of banks’ total deposits, a lower Repo rate has a very small direct impact on the average cost of funds.

2) There’s indirect transmission of Repo rate cuts, but since most deposits are contracted at fixed rates, banks have to continue to pay these rates till maturity.  Lowering lending rates in this scenario impact margins.

We explained above how there’s little direct impact of a Repo rate cut on the cost of funds, and thus little transmission to lending rates.  There is however an indirect way that the transmission mechanism works through the debt market. When the Repo rate is cut, yields on government and corporate bonds fall. This means that investors now get lower returns from debt securities, which means that banks have leeway to cut deposit rates in line with the lower interest rate environment. The problem that arises now though, is that even when banks cut interest rates on new term deposits, since their existing term deposits were contracted at fixed rates, they have to continue to pay these higher contracted rates till these deposits mature. As a result, even when banks cut deposit rates, their cost of funds does not change much in the short term. This makes it hard for them to cut base rates/ lending rates, without impacting their NIMs (net interest margins). 

3) Lower Repo rate means lower yield on government securities which means lower treasury income from banks’ SLR securities. This actually puts pressure on banks to not cut lending rates. (Opposite of the desired impact)

When the RBI cuts the Repo rate, yields on government bonds fall almost immediately. While this provides banks with instant “capital gains” or mark-to-market gains from the increase in the value of their SLR portfolio (price of bonds inversely proportional to their yield), the interest income that they receive from their SLR assets goes down, thus impacting their Net Interest Margins (NIM). This actually discourages them from reducing their lending rates because they now have to make up for the loss of treasury income from their loan assets. This leads to low transmission of the Repo rate cut to bank lending rates.

Bottom-line: Transmission of Repo rate cuts is not as intuitive as it seems. Infact, transmission is a complicated, controversial subject.