In recent developments, the Reserve Bank of India (RBI) made a significant decision regarding the repo rate, but despite this, the loan rates continue to rise. Ankit Agrawal’s explanation on this topic brings out the underlying reasons behind this paradox. In this post, we’ll break down the factors affecting the scenario and explain why the expected drop in loan rates hasn’t materialized.
Background of RBI’s Recent Rate Cut
Back in 2020, when the COVID-19 pandemic significantly impacted the Indian economy, the RBI took steps to boost the country’s growth. The GDP growth rate was plummeting, and to counter the situation, the RBI slashed the repo rate to a historic low of 4%. This rate remained stable for almost two years.
However, by 2022, inflation started rising, prompting the RBI to begin increasing the repo rate in response. As a result, by 2023, the repo rate reached 6.5%. Now, in 2025, concerns are emerging again regarding slowing growth, as evidenced by the 5.4% GDP growth rate in the third quarter of 2024. This has led the RBI to focus on encouraging growth again, resulting in a rate cut by 0.25% to 6.25%.
What the Rate Cut Means for Loan EMIs
When the RBI reduces the repo rate, the general expectation is that commercial banks will pass on this benefit to consumers, leading to a reduction in loan interest rates, and consequently, a decrease in monthly EMI amounts. This would typically boost disposable income and consumer spending.
However, there’s a catch: despite the RBI’s rate cut, commercial banks are not reducing loan interest rates. Instead, some banks have even raised their rates. For example, UCO Bank increased its Marginal Cost of Funds Based Lending Rate (MCLR) by 0.05% shortly after the RBI’s rate cut. This contradiction has puzzled many, and Ankit Agrawal delves into the reasons behind it.
Why Banks Aren’t Passing On the Rate Cuts
The fundamental question here is: why aren’t banks lowering their loan rates despite the repo rate cut? There are several factors at play:
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Cost of Borrowing for Banks: Banks borrow from the RBI at the repo rate, but this rate only applies to a limited amount of borrowing. The bulk of the funds that banks use come from deposits. Banks pay interest on these deposits, and if they increase the deposit interest rates to attract more funds, they cannot afford to lower their lending rates drastically. This discrepancy between the deposit interest rates and loan rates leads to higher lending rates, even when the RBI reduces the repo rate.
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Liquidity Concerns: In an environment where liquidity is tight, banks are eager to attract deposits. Higher deposit rates allow them to draw in more funds, but it also raises their cost of capital. Therefore, to ensure profitability, banks have to maintain higher loan interest rates.
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Bank Profitability: Banks are in the business of making a profit, and if the cost of their funds (through deposits) increases, they cannot simply lower the loan rates. For instance, if a bank offers a 7% interest rate on fixed deposits, and it borrows at a rate of 6.25% from the RBI, they must charge higher loan rates to maintain their margins.
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Transmission Lag: Even when the RBI cuts rates, there’s often a delay in how these rate changes are transmitted to the lending rates. Banks may choose to keep their lending rates high if they anticipate that the RBI’s rate cuts are temporary or if they foresee other economic challenges, such as rising inflation or global financial instability.
The Role of Liquidity Management by RBI
The RBI controls liquidity in the economy through various mechanisms, including the buying and selling of government bonds and adjustments in foreign exchange markets. The RBI’s recent efforts to manage inflation by selling government bonds have resulted in reduced liquidity in the system. When liquidity is tight, banks may be reluctant to lower rates since they have to compete more aggressively for deposits, raising the cost of funds.
In addition, foreign institutional investors have been pulling out of the Indian stock market, converting their investments into foreign currencies, which further strains the Indian rupee and increases the demand for liquidity in the system.
Final Thoughts
The RBI’s recent decision to cut the repo rate was aimed at stimulating growth. However, the lack of corresponding reductions in loan rates is a result of the complex dynamics in the banking sector. Banks are facing higher costs due to the need to offer attractive interest rates on deposits to maintain liquidity. Additionally, concerns over inflation, liquidity management, and economic uncertainty are making banks cautious in reducing lending rates.
While rate cuts typically lower loan EMIs, the current economic environment is preventing a smooth transmission of these cuts. Understanding these mechanisms is essential for anyone trying to make sense of the current financial landscape in India.
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