Policy Transmission and Its Importance in India’s Monetary Framework

Monetary policy transmission refers to how changes in a central bank’s policy rates (like the RBI repo rate) pass through the banking system to influence lending rates, credit growth, consumer spending, and ultimately, the broader economy.

In simple terms, when the Reserve Bank of India (RBI) cuts policy rates, it expects banks to reduce lending rates so that borrowers pay less interest, borrow more, and invest or spend more, boosting economic activity.

However, effective policy transmission depends on how quickly and fully banks adjust their lending rates in response to the RBI’s policy moves. When transmission is smooth, RBI rate cuts stimulate the economy as intended. When it’s sluggish, the central bank’s efforts to support growth are partially blunted.

Fixed-Rate Loans: A Structural Hurdle

Recent data highlighted in the Chart of the Day underscores a key challenge: private sector banks in India have a high share of fixed-rate loans in their portfolio. Unlike floating-rate loans, which automatically adjust with changes in the RBI’s repo rate, fixed-rate loans lock borrowers into a set interest rate for a defined period.

This structure slows or even prevents transmission, because even if the RBI slashes rates:

• Existing borrowers with fixed-rate loans continue paying the old, higher rate.

• Banks do not immediately reprice these loans downward.

• Only new loans (which may be offered at lower rates) reflect policy changes, and even that depends on competitive dynamics.

As a result, the overall average lending rate in the economy declines only slowly, diluting the RBI’s monetary stimulus.

How Does This Affect Borrowers and the Economy?

For borrowers, particularly retail customers (home loans, auto loans, personal loans) and small businesses:

• Fixed-rate loans mean no immediate relief when rates fall.

• Monthly repayment burdens remain high, reducing disposable income and consumption.

• Investment by SMEs (which might depend on cheaper credit) stays subdued.

For the economy:

• Slower credit growth undermines the RBI’s efforts to stimulate demand.

• Private consumption, a major driver of India’s GDP, grows at a slower pace.

• Businesses face higher financing costs, delaying capacity expansion and hiring.

In short, fixed-rate lending reduces the effectiveness of monetary easing, limiting India’s growth potential.

Why Do Private Banks Prefer Fixed-Rate Loans?

There are several reasons why private sector banks favour fixed-rate products:

• Revenue predictability: Fixed rates ensure steady interest income for banks, even when policy rates fall.

• Risk management: By locking in rates, banks reduce interest rate risk on their books.

• Product design and marketing: Fixed rates appeal to borrowers seeking certainty in EMIs, making them popular despite rate cycles.

• Competitive strategy: Fixed-rate pricing can be used aggressively to acquire market share when rates are low.

While these factors make sense from a commercial perspective, they complicate monetary policy implementation at the system level.

The Difference Between Private and Public Sector Banks

Data shows that public sector banks (PSBs) typically have a higher share of floating-rate loans, especially in retail home loans, which are often benchmarked to the External Benchmark Lending Rate (EBLR) linked directly to the RBI’s repo rate.

As a result:

• PSBs pass through rate changes more quickly.

• Their borrowers benefit sooner when the RBI cuts rates.

• Transmission is generally better in PSBs than private banks.

This divergence creates an uneven landscape:

• Borrowers with PSBs enjoy lower rates during easing cycles.

• Borrowers with private banks see smaller, slower benefits.

RBI’s Push for Better Transmission

The RBI has long been aware of these issues and has tried to address them through:

• Mandating external benchmarks: Many retail and MSME loans now have to be linked to repo rates or other external benchmarks.

• Guidelines on transparency: Banks must clearly communicate rate resets and loan terms.

• Monitoring and reporting: The RBI regularly tracks and publishes data on lending rates to push banks towards more responsive pricing.

However, these measures mainly affect new loans. Existing fixed-rate contracts remain a structural drag unless they are refinanced or renegotiated—often a costly and cumbersome process for borrowers.

The Broader Economic Context

India’s economy, like many others, has faced multiple shocks in recent years:

• COVID-19 pandemic, which required massive policy support.

• Global inflation spikes, leading to RBI rate hikes to contain price pressures.

• Geopolitical uncertainties, affecting trade and investment.

As inflation moderates and the RBI considers easing policy rates to boost growth, effective transmission is crucial. But fixed-rate lending patterns in private banks risk weakening the stimulus precisely when the economy needs it most.

Implications for Policymakers and Borrowers

For policymakers:

• Need to encourage greater adoption of floating-rate lending.

• Promote easy refinancing to help borrowers switch from old fixed-rate loans.

• Enhance financial literacy, so borrowers understand rate risks and options.

For borrowers:

• Consider floating-rate options to benefit from rate cuts.

• Understand prepayment and refinancing terms to avoid being locked into expensive loans.

• Compare loan products across banks to ensure best rates and flexibility.

Global Comparisons

In many advanced economies, floating-rate loans dominate, especially in mortgage markets, enabling quick monetary transmission. For example:

• In the UK, most mortgages are variable-rate or have short-term fixed periods.

• In Australia, variable-rate lending is the norm.

• In Europe, many countries have hybrid models with capped variable rates.

India’s challenge is balancing borrower protection (certainty of EMIs) with macroeconomic needs (fast transmission).

The Way Forward

To strengthen policy transmission in India, a multi-pronged approach is needed:

1. Regulatory nudges to expand floating-rate lending in retail and MSME segments.

2. Product innovation to make floating rates attractive but predictable (e.g., capped floats).

3. Digital platforms to ease loan comparisons and refinancing.

4. Improved competition so banks have incentives to lower rates quickly.

5. Consumer education to empower borrowers to make informed choices.

The RBI’s role will be central, ensuring banks’ commercial strategies don’t undermine monetary policy goals.

Conclusion

The Chart of the Day highlighting private banks’ reliance on fixed-rate loans shines a light on a critical but underappreciated challenge in India’s financial system.

Effective monetary policy transmission is essential for steering the economy. Yet, the structure of lending products—especially the dominance of fixed-rate loans in private banks—creates a significant hurdle.

Addressing this requires coordinated efforts by the RBI, banks, policymakers, and borrowers themselves. Only then can India ensure that when the central bank acts to support growth, the benefits truly reach the economy quickly and fully.

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