Lack of capital prevents banks from transferring rate cuts: RBI staff study

Markets do not view banks with low capital favourably and offer funds at a higher rate, says study done independently.

Banks are unwilling to pass on policy rate cuts by the Reserve Bank of India (RBI) because they lack capital, a working paper by the staff of the central bank has said. The government, therefore, should infuse more capital in state-owned banks for healthy credit growth at a cheaper rate.

The study is not necessarily the view of the central bank and the research done for it is independent.

There have been many theories on why banks in India don’t pass on policy rate cuts: the need to keep a minimum rate to protect depositors’ interest, the rigidity of small savings rate, and high bad debt are among reasons given. The study said that capital constraint can push up credit cost.

Markets do not view banks with low capital favourably and offer funds at a higher rate. When a stressed bank is recapitalized, the market rewards it “in the form of a reduction in its risk premia,” said the study titled ‘Bank Capital and Monetary Policy Transmission in India “ by Silu Muduli and Harendra Behera, who work in the Department of Economic and Policy Research of the RBI.

The RBI has followed an easy monetary policy since January 2014 by reducing policy rate (except a monetary policy rate hike in August 2018) and to provide more liquidity to the banking system through reduction in statutory liquidity ratio (SLR). But that didn’t result in a pick-up in credit growth, signaling weakening of the bank lending channel of monetary policy transmission.

India is not alone in this: the same phenomenon was observed in the United States in the early 2000s and in Japan.

According to the researchers, equity is countercyclical and leverage is procyclical, and given that the Indian banking system is dominated by public sector banks and they do not have excess capital, “it is difficult for them to extend credit without improving their capital position during the downturn of the current business cycle,” the paper said, adding, the countercyclical nature of capital provides evidence that the banks are trying to raise capital to meet provisioning requirements during the downturn.

The study found that an increase in leverage, which banks raise through debt instruments, raises the cost, while a rise in capital position of banks reduces the cost. In other words, well-capitalised banks with lower leverage face a lower cost of funds, as proven in other studies globally as well.

In the Indian case, the researchers found that banks having gross non-performing assets (GNPA) ratio above 4.98 per cent (6.54 per cent for public sector banks), a rise in capital adequacy ratio (CRAR) could result in a significant reduction in costs. Hence, evidences justify the benefits of implementing public sector recapitalisation policy to revive the health of the banking sector, the researchers said.

For each one percentage point increase in capital adequacy ratio (CRAR), loan growth rises by 7.8 percentage points rise. On the contrary, one percentage point increase in GNPA ratio reduces the loan growth rate by 0.9 percentage points.

“Therefore, it is always an optimal strategy for any bank to go for higher capital and lower GNPAs to experience better loan growth,” the paper said.

Higher CRAR also helps in smooth transmission of monetary policy whereas massive GNPAs in the banking sector adversely influence the channel.

“For all banks, monetary policy is 1.5 times more effective if CRAR is below 12.17 per cent,” according to the paper.

However, this argument holds true up to a certain level of capital. Even as CRAR unlocks the bank lending channel and helps in smooth transmission of monetary policy, “the magnitude of transmission of monetary policy was found to be weak for banks with CRAR higher than a certain threshold level,” the paper said.

The researchers found that for Indian banks, one percentage point rise in CRAR increases debt growth rate by 1.8 percentage points (3.5 percentage points for public sector banks).

“When we control for stressed assets, it reduces to 1.4 percentage points (3 percentage points for public sector banks). Similarly, the sensitivity of borrowing growth to CRAR reduces from 6.8 percentage points to 5.5 percentage points in the presence of GNPAs, while for public sector banks it reduces from 9.3 to 6.8 percentage points,” the researchers said.

The sensitivity of borrowings by the banks to CRAR is much higher for public sector banks as compared to all banks. Public sector banks have lower capital, but have implicit insurance from the government, which enables them to borrow more with every additional recapitalisation by the government as compared with private and foreign banks.

However, the rise in stressed assets “significantly lowers the debt growth as well as borrowing growth.” For one percentage point increase in GNPA ratio, debt and non-deposit growth reduce by 0.8 percentage points and 1.9 percentage points, respectively for the banking system. In the case of public sector banks, it is 0.3 and 1, respectively. This is also because of the government insurance on public sector banks.