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RBI policy: What should determine interest rates

As we have pointed out in the past, the repercussions of banks blindly following the RBI's diktat go well beyond the banking sector.

ET Bureau|
Updated: Apr 25, 2012, 10.06 AM IST

Less than a week after the Reserve Bank of India (RBI) announced a 50-basis-point reduction in the repo rate — the rate at which it lends to commercial banks — major banks obediently cut their deposit and lending rates, albeit by 25 basis points in most cases.

What explains their synchronised behaviour, more correctly, the about-turn, since just a day or two earlier, they were doubtful they could reduce rates given the high cost of funds and tardy growth in deposits? There are just two possible explanations. The first, the monetary transmission mechanism has suddenly become super-efficient. Never mind what the RBI might say to the contrary, it has only to cut rates and, hey presto, banks respond and in unison.

The second, and more likely, explanation is that both public sector banks (PSBs) and private sector ones, make good poodles. Asked to choose between standing up to a powerful banking sector regulator and pricing their loans and deposits on commercial considerations, they'd rather fall in line than risk the wrath of the regulator backed by the not-so-invisible hand of the government.

Their action reportedly follows a letter from the finance secretary to the chairmen of PSBs. Once PSBs cut rates, private sector banks have no choice but to follow. It is a shrewd decision. As the 2008 financial crisis has shown, the normal rules of the game do not apply to banks. While profits are theirs, losses are borne by taxpayers, regardless of whether they are publicly- or privately-owned.

So, they do not have to worry if, in following the RBI's 'diktat', they end up making losses. But as we have pointed out in the past, the repercussions of banks blindly following the RBI's diktat go well beyond the banking sector.

The sharp increase in the bad loans of public sector banks and, hence, in taxpayerfunded capital infusions, for instance, is the direct consequence of PSBs lending aggressively at the RBI's behest during the downturn when commercial considerations called for a cutback in lending. It is unfortunate that instead of learning from past mistakes, we seem determined to repeat them.

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