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The recent Annual "Currency and Finance- Report of the Reserve Bank of India revealed that between March 1998 and February 2003, the Bank Rate and the repo rate were cut by 425 basis points and 250 basis points, respectively. In addition, the CRR was reduced by 550 basis points over the same period. However, the prime lending rates of major banks remained sticky. This suggests a low level of pass-through of the changes in the policy rates on to the lending rates, thereby blunting the efficacy of the monetary policy. In essence despite these falling interest rates, the benefits of low interest rates have not been fully passed on to the borrowers. Further, the pass-through is asymmetric i.e., the loan rates react faster to tight policy initiatives while it is slow when the policy is eased. .
The relative downward inflexibility in the commercial bank interest rate structure can be attributed to a number of structural factors in the banking system. One factor is that the average cost of deposits for major banks is relatively high at 6.25 - 7.25 per cent, partly due to the higher administered returns on alternative savings instruments in the country, thereby constraining banks' ability to reduce deposit rates. Other reasons attributed for low level of pass-through' is that a substantial portion of bank deposits being long-term deposits at fixed interest rates, which limits the flexibility available to banks in reducing their lending rates in the short-run without adversely affecting their return on assets. High over-hang of non-performing assets, particularly for public sector banks, further pushes up the average cost of funds. .
The current slowdown of economy has heightened the probability of defaults and late payments by borrowers, which has led to stickiness in PLR due to increase in risk premium. .
To overcome these rigidities the Reserve Bank has recently encouraged banks to introduce a flexible interest rate system option for new deposits and urged them to review and announce maximum spreads over PLR.
