Recently RBI has increased repo rate by 25 basis points and there is a huge cry in the market that RBI is targeting price containment. Repo rate is a rate at which central bank lends money to commercial banks only in the event of shortfall of funds or liquidity.
This to me has very less bearing for less than 2% of the total capital that banks use for lending is being lent by RBI to commercial banks. On the other hand, MSF (Marginal Standing Facility - also referred to as overnight rate) has been reduced by about 75 basis points. It is a no brainer - if i borrow from central bank at repo rate, this means it is more of a long term borrowing and i will have to stick to certain conditions laid down by the central bank. On the other hand, if i can borrow overnight from central bank at a higher rate, i don't need to contain myself. So banks typically go for overnight borrowings because their business of lending and investing is not dependent on how much or at what rate they can borrow from Central bank rather it depends on the deposits, the deposit rate (which is always higher than MSF to attract more deposits otherwise people can invest in government bonds and schemes such as PPF that offer rates on par with MSF), and provision for credit loss. So as long as the deposits are healthy and there is not much fear of NPA (Non performing assets), liquidity should not be a concern (baring for one odd glitches here and there). In addition, there is also inter bank lending (i think in India, we follow Mumbai inter bank lending rate which is correlated with LIBOR) so there is very limited reason why a commercial bank would reach out to RBI for borrowings. Having done some good research on how banks are evaluated (at least here in Canada while speaking to a few banks here), i can say that repo rate barely affects the lending scenario for it largely depends on deposit rates offered by individual banks. So this means that price containment using repo rate adjustment is barely going to work!
Now what has this MSF got to do with lending rates. I think with the introduction of MSF (in 2011), RBI has clearly laid instructions to the banks (in directly) that you cannot lend below this rate (MSF set by RBI). In fact this has brought about some transparency to the entire system. Earlier banks used to lend at different rates to different individuals and they still continue to do so. However the difference has largely come down. So going by the practicalities, if RBI has reduced MSF rate by 75 basis points, doesn't it mean that it's strategy is not liquidity containment and as a result price stability but rather growth. However by increasing the repo rate, it is signaling the world that price stability is it main agenda.
In India, banks barely have problem with deposits although the loan to deposit ratio is looming but most of the banks have a very healthy capital to risk bearing asset ratio and their operating efficiency is above the global average. One factor that could distort this scenario a bit is Non performing assets (NPA). Should the economy progress at the same snail pace, banks might experience rising NPAs. In addition, the concern now in India is rising deposit rates (has crossed 10% - offered by some banks) and this means your loans are getting even costlier. But the income levels of businesses and individuals are not growing at same pace and so banks are starting to lend at higher tenures and also have removed the pre-payment penalties. This to some extent could counter NPA but the larger question remains as to who is actually defaulting on the loans. If it is the common man, extending the tenure and giving flexibility of pre payment might help.
Mr Rajan, way to go! Just open up the banking reforms and issue the licenses that were due for some time. This will increase banking access to larger population because as of now in India, only 35% of the population has a bank account as against 50% world average. Already we have seen that you have removed some regulatory hurdles for commercial banks while setting up branches (previously commercial banks had to file a document with RBI seeking permission and now you have removed this hassle), which will for sure increase reach.
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