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Time for govt, RBI to rethink bank architecture

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Various policy rates of the RBI.

Mains level : Paper 3- What were the measures announced by the RBI to deal with the impact of Covid-19 on economy and how far were the measure successful in achieving the intended goals?

To deal with the damage inflicted by the corona crisis on the economy, both the RBI and the government are planning various monetary and fiscal measures. In its latest measures, the RBI has further reduced the reverse repo rate. This article discusses the impact of these measures and explains why the first round of measures failed in achieving the desired result.

What was announced in the second round of policy measures by the RBI?

  • RBI reduces the interest on money banks keep in the central bank (reverse repo down by 25 basis points).
  • RBI gives ₹50,000 crores to banks through targeted long-term repo operations or TLTRO 2.
  • And another ₹50,000 crores to Small Industries Development Bank of India (Sidbi) and National Bank for Agriculture and Rural Development (Nabard) to lend to microfinance institutions (MFIs) and non-banking financial companies (NBFCs).

Banks not transmitting the money

  • Banks globally have a problem.
  • They are not transmitting the money that central banks are providing to businesses that need the money.
  • Imagine that the world has been put into a business coma as we wait for the pandemic to recede.
  • Money to pay rents, interest and salaries is needed by the business to stay alive during this period and banks are showing reluctance to step in.
  • Firms and tiny entrepreneurs need to borrow to stay afloat.
  • Banks typically lend to the larger part of the market and NBFCs and MFIs to the rest—they provide the last mile that banks do not.

Measures by the RBI to increase the money supply in the market

  • The US Fed buying bonds directly: The US Federal Reserve has taken to buying corporate bonds directly rather than through banks.
  • RBI has not gone that far, but is using its firepower to nudge banks to lend to those who are credit-worthy and who desperately need the money.
  • It has done two things to facilitate this.

What reduction in Reverse Repo rate by the RBI means?

  • What is reverse repo rate? This is the rate at which banks lend to the central bank—they keep their surplus money with the RBI and get some interest on it.
  • Banks borrow from RBI at the repo rate, which is 4.4% right now.
  • A few weeks ago, the central bank had reduced the reverse repo by a larger percentage than the repo to decrease the incentive to banks to keep money with RBI.
  • But that had a limited impact as on 15 April, banks still had almost ₹7 trillion with the RBI under this window.
  • In the second round, RBI has cut the reverse repo by another 25 basis points to 3.75% to increase the difference between the borrowing rate and the lending rate.
  • What would be the impact of the second reduction in the reverse repo? The RBI is hoping that this would make banks lend to firms, rather than keeping their money safe with RBI.
  • The difference between the rate of borrowing and lending is now 65 basis points.

An issue of monetary policy transmission is a recurring one. The RBI always try to ensure the transmission but there are several factor that prevent it. Make note of these factors.

Risk aversion of the banks

  • Banks are displaying deep risk aversion—the desire to keep their capital safe rather than risk investing in investment-worthy bonds.
  • The first round of money put into the system through TLTRO 1.0, brought ₹1 trillion.
  • TLTRO is long-term (one-to-three years) funding to banks at the repo rate or a short-term rate.
  • TLTRO money didn’t reach small and medium firms: Banks took the cheap loan and lent to high-rated public sector units (PSUs) and AA-plus firms—essentially entities who had enough liquidity.
  • The money did not find its way to smaller and medium firms, NBFCs and MFIs—entities that actually reach the last mile.
  • RBI has put another ₹50,000 crores as part of TLTRO 2.0.
  • Banks can only get this money if they lend to NBFCs and MFIs.
  • For A and A-minus (these are still investment-worthy) bonds issued by firms in these sectors, banks stand to get a return of between 10-14%.
  • Banks are borrowing at 4.4% and have the option to lend at a multiplier.
  • That is the incentive given by the RBI to get money down the pipeline.
  • Banks stand to lose 65 basis points if they seek the safety of money with the RBI or stand to gain almost 6-10 percentage points in interest if they lend.
  • It remains to be seen if banks take this nudge and begin lending to lower than the highest safety bonds.

Refinance to three institutions

  • Another ₹50,000 crores is being provided as a refinance to three institutions-Sidbi, Nabard and National Housing Bank.
  • These banks reach the small-scale firms, rural sector, housing finance firms, NBFCs and MFIs.
  • Again, this should help money reach the last mile.
  • Clearly, there is too much competition at the top end of the market—everybody wants the safe paper and deals.

The UPSC could ask a direct question with reference to the issue of policy transmission and how it is a serious challenge in crisis such as Covid -19. So, following are some suggestions to deal with this issue.

Way forward

  • Rethink the bank architecture: With transmission, or the liquidity given by the central bank not going down the line, maybe this is a good time for the government and the RBI to rethink its bank architecture.
  • Develop bond a corporate bond market: There is very little action at the middle and lower end of the market. The development of a robust corporate bond market will help.
  • Early alarm system: The setting up of an early alarm system as proposed by the Financial Resolution and Deposit Insurance (FRDI) Bill to prevent a financial firm failure that takes the whole system down would be a step in the right direction.

Back2Basics: What is the transmission of monetary policy?

  • Monetary transmission refers to the process by which a central bank’s monetary policy signals (like repo rate) are passed on, through the financial system to influence the businesses and households.
  • There are many monetary policy signals by the RBI; the most powerful one is the repo rate.
  • When repo rate is changed, it brings changes in the overall interest rate in the economy as well.
  • As a result of a decrease in repo rate, the interest rate on loans by banks also changes and this encourages consumption and investment activities of businesses and households.
  • In an economy, both consumption and investment are often financed by borrowings from banks.
  • As the repo rate brings changes in market interest rate, the repo rate channel is often referred to as interest rate channel of monetary transmission.
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