Repo rate transmission refers to how swiftly and significantly changes in the Reserve Bank of India’s (RBI) repo rate affect the interest rates that banks offer on loans and deposits. When the RBI cuts the repo rate, banks are anticipated to reduce their loan and deposit interest rates, thereby encouraging borrowing and consumer spending.
Effective transmission of the repo rate is crucial for the success of monetary policy. When transmission is smooth, a lower repo rate can lead to cheaper home loans, car loans, and business loans. This mechanism signals to the market that the central bank aims to stimulate growth or manage inflation, depending on the prevailing economic conditions.
Despite a reduction in the repo rate, banks may sometimes hesitate to lower lending rates. This is often due to their reliance on long-term deposits for funding loans. If these deposits are at fixed interest rates, banks cannot quickly reduce their costs. For instance, if a bank is committed to paying 7% on existing fixed deposits, it may be reluctant to decrease new loan rates to 8%, as this would shrink their profit margins.
MCLR, or Marginal Cost of Funds-Based Lending Rate, is determined by a bank's internal cost structure, whereas external benchmark-linked rates like the repo rate align directly with RBI’s policy. Loans tied to repo-based benchmarks can adjust more rapidly. For example, when the RBI reduces the repo rate, loans linked to this rate are amended in the following month, while MCLR-based loans might take longer to reflect such changes.
Deposit rates often decline more slowly than lending rates. This is primarily because depositors, especially small savers and retirees, prefer stable returns. If banks reduce deposit rates too quickly, it may lead to withdrawals as savers seek higher returns elsewhere, such as in mutual funds. A sudden drop in savings interest from 6% to 4% could prompt savers to move their funds out of banks.
Repo transmission has seen improvements in recent years, although progress has been uneven. Lending rates have become more responsive due to the introduction of external benchmarks, while deposit rates still adjust slowly. For instance, when repo rates sharply decreased, loan rates for housing and small enterprises fell swiftly, but banks remained cautious in reducing deposit rates to avoid losing funds.
While improved transmission can facilitate higher growth, it does not guarantee it. Lower interest rates can indeed stimulate borrowing, but only if consumers and businesses feel confident about their financial situations. During economic downturns, even lower loan rates may not motivate spending if individuals are uncertain about job security or income stability.
Q1. What is repo rate transmission?
Answer: Repo rate transmission is the mechanism by which changes in the RBI's repo rate influence the interest rates on loans and deposits offered by banks.
Q2. Why is effective transmission crucial?
Answer: Effective transmission ensures that changes in the repo rate directly impact borrowing and spending, aiding in economic growth or inflation control.
Q3. Why do banks hesitate to lower lending rates?
Answer: Banks may hesitate to lower lending rates due to their reliance on long-term fixed deposits, which limit their ability to reduce costs quickly.
Q4. What differentiates MCLR from external benchmarks?
Answer: MCLR is based on a bank's own cost structure, while external benchmarks like the repo rate adjust directly with RBI's policy, allowing quicker rate changes.
Q5. How do deposit rates react to repo rate changes?
Answer: Deposit rates often fall more slowly than lending rates due to depositor preference for stable returns and the risk of fund withdrawals.
Question 1: What does repo rate transmission refer to?
A) The speed at which banks adjust loan rates
B) The effect of RBI's repo rate on interest rates
C) The relationship between inflation and interest rates
D) The process of adjusting deposit rates
Correct Answer: B
Question 2: Why might banks not lower lending rates despite a repo rate cut?
A) Increased competition
B) Fixed interest rates on long-term deposits
C) High liquidity in the market
D) Government regulations
Correct Answer: B
Question 3: What is MCLR?
A) A fixed deposit rate
B) A lending rate based on market trends
C) Marginal Cost of Funds-Based Lending Rate
D) An external benchmark for loans
Correct Answer: C
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