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RBI cutting leverage ratio shows the direction, but there are more things to consider

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The RBI's latest monetary policy meeting was along expected lines with a 0.25 percent cut in repo and reverse repo rates.

However, the lack of any significant or concrete measure to contain the brewing liquidity crisis in the NBFC space has led to some disappointment (the stock market - Nifty 50 - closed 1.5 percent lower on the policy day).

Unless the rate cut of 0.25 percent and the previous two rate cuts of 0.25 percent each in February 2019 and April 2019 (amounting to a total of 0.75 percent) are completely passed to the end user, the RBI's decisions do not have much practical meaning. Till now, rates on new loans have fallen only by around 0.21 percent while rates on existing loans have increased by around 0.04 percent.

Banks and NBFCs point to falling deposits and high costs of capital for their inability to price loans cheaper. If the deposit collection is lower, banks cannot reduce deposit rates, which implies they will not be able to reduce lending rates. Similarly, if their cost of borrowing funds from the market is high (due to the ongoing liquidity crisis, cash is at a premium), they cannot lend to end consumers at lower rates. The RBI needs to work closely with them to solve this problem first.

The RBI also changed its monetary policy stance from neutral to accommodative, given the growth slowdown being currently witnessed. This is a good signal which shows the RBI's bigger fear is the falling economic growth, as compared to inflation (which has been low for quite some time and reasonably well-contained) at least for the foreseeable future.

Another important measure taken on June 6 that was not a part of the main monetary policy report was the RBI’s guidance to target 4 percent leverage ratio going ahead (against 4.5 percent currently) for domestic systemically important banks (like HDFC Bank, ICICI & SBI) and 3.5 percent for other banks.

The leverage ratio is defined as the ratio of a bank’s tier 1 capital (core assets such as equity capital and disclosed reserves) by its total consolidated exposure. A cut in leverage ratio implies that banks can lend more on the same capital base.

Given that current total consolidated exposure for the banking sector is around Rs 96 lakh crore, this decision gives the ability for lending to increase by approximately Rs 50,000-75,000 crore for the entire banking system as a whole.

The RBI's intention is that this excess money will reach sectors that are currently starved of liquidity especially MSME businesses. But, it remains to be seen how money much actually circulates into the economy.

On the whole, the RBI’s policy decisions were a step in the right direction. Now, it is time their benefit reaches the end customer.