Transmission lower at weakly-capitalised banks during easing cycle, says RBI report

Banks with higher capital ratios transmit monetary policy actions more smoothly than banks with lower capital base. Given that the chunk of the banking sector lending pertains to public sector banks and they do not have excess capital, it is difficult for them to extend credit without improving their capital position during the downturn of the current business cycle. Despite the RBI’s easing policy since 2014 (except for two intermittent rate hikes in 2018), credit growth has not picked up in the past few years, signalling weakening of bank lending channel of monetary policy transmission.

These are some of the findings of a recent study by the RBI in its working paper titled ‘Bank Capital and Monetary Policy Transmission in India’.

A recent BusinessLine report had also revealed a similar link between bank balance sheets and credit growth. Bank credit is mostly a function of the underlying activity in the economy. But aside from the sharp fall in GDP growth in the past few years, bank credit growth has also been impacted by banks’ weak balance sheets. This is evident from the shrinking bank credit to GDP growth multiple over the past three to four years. Bank credit growth until FY14 was mostly 2.5-3 times the real GDP growth or 1-1.2 times nominal GDP growth. But since FY15, this multiple has shrunk substantially to 1-1.5 times real GDP growth and under one time nominal GDP growth.

The RBI study attempts to understand the link between bank capital and monetary transmission by looking at the relationship between bank capital and loan growth/cost of funds. It states that for each one percentage point increase in CRAR, there is 7.8 percentage points rise in loan growth rate. On the contrary, one percentage point increase in GNPA ratio reduces the loan growth rate by 0.9 percentage points. In effect, while rise in capital ratio helps in better monetary policy transmission, significant amount of stressed assets could limit credit supply.

Capital and loan growth

According to the RBI report, the bank lending channel of monetary policy transmission stands on the view that central banks can alter the banks’ credit supply by tightening monetary policy, either through increasing reserve requirement or raising short-term interest rate. This can cut down access to loanable funds and reduce loan extension by the banks (vice versa in an easing policy phase).

But structural issues at banks have dampened such transmission of monetary policy. Sustained asset quality stress, which has eroded capital, has impacted the capacity of banks to lend over the past few years. Hence, even in a falling rate scenario, when banks should ideally be induced to expand credit, inadequate capital has limited their lending activity.

Sample this. Since Jan 2014, policy repo rate has been trending lower (except for a 50 bps increase in 2018) — between January 2014 and January 2020 the repo rate fell by a tidy 285 bps. Bank credit growth, however, has been mostly languishing in single-digit since FY15. PSBs that constitute about 70 per cent of the overall lendinghave been the key reason for this muted show, owing to their weak capital ratios.

This is because when banks extend credit, in particular to risky sectors, the risk-weighted assets increase and lead to lower CRAR. Banks with weak capital hence limit lending to private sector, and instead park funds in risk-free government bonds.

Capital and cost of funds

A bank can fund its lending by issuing new debt or with excess equity capital. But in a weak economic environment (such as the one seen in the past few years), banks raise capital to meet higher provisioning requirement owing to deterioration in asset quality. According to the RBI report, banks might depend on their ability to raise fund by issuing debt contracts in the capital market to meet the credit demand. Hence, it examines whether capital helps the bank in raising external fund by lowering their cost of funds.

The RBI study finds that a one percentage point rise in CRAR increases debt (total outstanding borrowings of a bank through debt instruments) growth rate by 1.8 percentage points (3.5 percentage points for public sector banks). The sensitivity of borrowings by banks to CRAR is much higher for PSBs because they have lower CRAR and, hence, an implicit insurance from their ownership (government) may lead to higher borrowings (on the back of additional CRAR) compared to banks with private and foreign ownership.

While a higher CRAR helps the bank in getting more funding, accumulated stressed assets may constraint the channel. Therefore, a bank with higher GNPAs, is more likely to have lower credit growth because of lesser borrowings and higher provisioning requirement.

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