Monetary transmission in simple terms is the mechanism through which changes in monetary policy affect real economic activity. Among the five key channels of transmission — interest rates, credit, asset prices, exchange rates, and expectations — the credit channel is particularly prominent in India, often working in tandem with the interest rate channel.

For central banks, monetary transmission is the magic wand to control activity in an economy to achieve the desired objectives.

Despite the ever-increasing focus on bank liabilities, this transmission theory has rarely been revisited. The 2008 Global Financial Crisis brought this aspect in forefront which led to prudential measures such the liquidity coverage ratio (LCR) and Net Stable Funding Ratio (NSFR). This was natural as Basel regulations were formulated on asset only assumption and ALM consideration have been a later inclusion, that too partially.

Monetary transmission through the liability channel of banks refers to how changes in monetary policy, affect the liabilities of banks, which in turn influence their lending behaviour and overall economic activity.

In the Indian context, it includes the responsiveness of banks to repo rate changes in mobilising deposits during interest rate cycles through changes in card rates and manage the asset-liability mismatch with minimal resort to wholesale funding.

RBI revising the definition of bulk deposits by raising the limit to ₹3.0 crore highlights this aspect.

Credit-deposit dynamics

This context is relevant to the recent debate on the elevated credit-deposit (C-D) ratio driven by credit growth outpacing deposit growth. RBI’s internal analysis using long-term data identified three past episodes of such divergence, all corrected through sharp contractions in credit.

These sharp corrections alter economic activity and decelerate growth dynamism. As the primary role of the intermediation sector is to channel funds to borrowers, the funds intermediated depend on the financing flexibility of lenders and when these conditions deteriorate, the volume of intermediated funds declines, forcing borrowers to cut investments and other economic activities.

A course corrective action demands equal treatment of both the liability and asset sides of banks.

Deposits, being a stable and reliable source of funding for banks, contributing nearly 80 per cent to banks’ balance sheet, allow banks to invest in longer-term, riskier assets, thereby augmenting economic growth. When monetary policy changes affect deposit levels, it influences the stability and liquidity of the banking system.

While the RBI safeguards borrowers’ interests and ensures transmission at a reasonable rate through linking loans to external benchmarks-based lending rate (EBLR) to promote financial inclusion, it allows banks to decide deposit rates based on their resource-raising capacity and deposit franchise.

Although deposit rates were deregulated long ago, there has rarely been any directive from the RBI to link deposit rates to specific external benchmarks. While banks offer external benchmark-linked term deposits voluntarily, these have not gained much traction among depositors compared to fixed-rate term deposits.

This raises questions about why deposit rates (savings) have become insensitive to changes in interest rates despite RBI’s efforts to deregulate bank deposit rates since October 2011. Savings bank deposit rates have remained mostly sticky and unresponsive to evolving macro-financial conditions.

Given that savings deposits comprise about 31 per cent of total deposits, the overall transmission to deposit rates remains low as savings deposit rates are immune to policy rate changes, except for the volatile portion of savings deposit.

Interest rate deregulations have allowed banks to set rates based on their business requirements. Although the behavioural models deployed by banks’ Asset-Liability Committees (ALCO) are robust in capturing deposit dynamics, continuous depletion in CASA deposits suggests that households are altering their portfolio strategies in search of better returns. This also demands a revamp of these behavioural models by banks in order to anticipate such large divergence between deposits and credit. In fact, such divergence is a fairly good indicator of business cycle.

Lending side

On the lending side, competition among banks empowers customers to secure better pricing. The share of EBLR loans in total outstanding floating rate loans increased to 57.5 per cent at the end of June 2024 (from 9.1 per cent at the end of March 2020), out of which 81.1 per cent are linked to the repo rate and 16.4 per cent linked to shorter-maturity Treasury Bills.

The increasing share of EBLR-linked loans with shorter reset periods intensifies transmission to the weighted average lending rates of scheduled commercial banks (SCBs). Loans linked to EBLR with short reset periods make banks more vulnerable to macroeconomic events than those linked to the marginal cost of funds-based lending rate (MCLR) or even the repo-linked lending rate (RLLR).

Households being the surplus sector in the economy, contribute 61 per cent to total bank deposits. Deposit channel entails the RBI’s ability to influence bank card rates, thereby affecting household intertemporal decisions on consumption and savings. This is important for long-term lendable resources in the banking system.

Since the RBI targets inflation, which influences deposits as higher inflation affects consumption-saving decisions, the deposit channel is critical to the RBI’s ability to achieve targeted inflation.

Unless the cost of banks’ liabilities moves in line with policy rates, as do interest rates in money and debt market segments, it will not be viable for banks to price their loans in response to policy rate changes in the long term.

In conclusion, the RBI’s recent focus on the credit channel has overshadowed the importance of the liability channel, which now demands attention from the perspective of financial stability.

As we discuss revisiting the flexible inflation targeting framework, it is worthwhile to also consider the deposit channel given its direct and indirect influence on the ultimate objective of price stability.

Probably it is worthwhile to even consider some prudential measures in RBI ALM directives that put a check the build up of large divergence while balancing the operational flexibility given to banks on the liability side.

The writer is Senior Economist, State Bank of India. Views are personal