When the Reserve Bank of India (RBI) changes the repo rate (the rate at which it lends money to financial institutions), it sends a strong signal about the direction of the economy. A rate cut typically aims to lower borrowing costs and encourage spending, while a rate increase seeks to rein in inflation by making loans more expensive.
However, the impact of these changes on lending rates is not immediate. This delay, known as transmission lag, helps explain why monetary policy changes take time to affect loans and borrowing costs. Understanding this lag gives consumers and businesses a clearer insight into how policy decisions play out in practice.
Understanding Transmission Lag and Its Impact
At its core, transmission describes how a change in repo rate trickles down through the financial system to affect deposit and loan rates, and ultimately, consumer behaviour. Efficient transmission means policy changes quickly translate into adjustments in lending and deposit rates, influencing spending and saving patterns. However, in practice, this process is rarely direct or immediate. The transmission lag reflects the time it takes for a change in repo rate to influence:
- Lending rates (for home, personal, and business loans)
- Deposit rates (like fixed or recurring deposits)
- Market sentiment and borrowing behaviour
Factors Contributing to Transmission Lag
The transmission lag occurs because changes in the repo rate do not immediately affect all parts of the lending process. Several factors play a role, and they include:
1. Existing Loan Agreements
Many loans, especially older home or auto loans, were signed under fixed interest rates or linked to older benchmarks like MCLR (Marginal Cost of Funds based Lending Rate). These don’t adjust automatically when the repo rate changes.
So, even if the RBI cuts the repo rate, financial institutions may not immediately reduce EMIs for those with older contracts.
2. Internal Cost Structures of Financial Institutions
Financial institutions don’t rely solely on RBI funds. They also raise money through customer deposits and other market instruments. If these costs remain high, a reduction in the repo rate may not be enough for financial institutions to comfortably lower loan rates.
3. Financial Health and Profit Margins
If a financial institution is under pressure to maintain profitability or is recovering from a period of high defaults, it might delay passing on the benefit of a lower repo rate. Even in the case of a rate hike, institutions might absorb part of the cost to stay competitive, depending on their balance sheet and growth priorities.
4. Nature of the Lending Product
Some products are more sensitive to policy rates than others. For instance, short-term business credit and working capital finance tend to be closely linked with repo rate changes. But personal loans or education loans may not react as quickly, depending on the underlying benchmark used.
5. Competitive Market Conditions
In a competitive market, financial institutions may hold off on changing rates immediately to protect market share. Especially after a repo rate hike, some loan providers might delay passing it on to customers, hoping to attract more borrowers before others adjust their rates.
How Long Does Transmission Lag Last?
While the duration of transmission lag isn’t fixed, historical observations show that it often takes anywhere from a few weeks to several months for a change in repo rate to fully reflect in the loan rates offered to consumers.
In some cases, the delay has extended up to six months, especially during periods of high economic uncertainty or fluctuating inflation expectations.
Different loans respond at different speeds:
- Home loans linked to the repo rate (post-2019) usually adjust within 1 to 2 months.
- Older home loans tied to benchmarks like Marginal Cost of Funds-based Lending Rate (MCLR) can take 3 to 6 months to reflect changes.
- Personal loans often see a 2 to 4 month lag.
- Business working capital loans linked to repo or MCLR react faster—often within weeks.
- Fixed deposits (FDs) adjust partially and typically within 1 to 3 months, depending on the financial institution’s policies.
Why Does Transmission Lag Persist?
While the RBI has taken notable steps to make monetary transmission smoother and faster, the journey isn’t without roadblocks. The process of passing on repo rate changes to consumers is affected by several structural and behavioural issues. These challenges vary across institutions, products, and borrower profiles, making the system slower than ideal.
Several factors slow down the transmission rate, and they include:
1. Multiple Lending Benchmarks
India has shifted over the years from base rate to MCLR, and then to repo-linked lending. This gradual change has improved transparency but has also added complexity. Existing loans under older benchmarks don’t respond immediately to policy shifts.
2. Slow Switching by Borrowers
Even when borrowers are eligible to switch to a repo-linked loan, many don’t. Sometimes it’s due to a lack of awareness; other times, it's due to procedural hurdles or switching fees. This slows down overall transmission.
3. Depositor Interests
Financial institutions also have to balance the expectations of depositors. If loan rates are reduced too quickly following a repo rate cut, without adjusting deposit rates, it could squeeze profit margins. Many institutions are cautious and stagger these changes over time.
How External Factors Influence the Lag
Even beyond internal mechanisms, external elements can further stretch the transmission timeline:
- Inflation Expectations: If inflation is volatile, financial institutions may hold off on changing rates, anticipating a reversal in monetary policy.
- Global Interest Rates: India doesn’t operate in isolation. Global monetary trends, especially those in major economies, can influence how Indian institutions respond.
- Liquidity in the Financial System: When there is already ample liquidity, a repo rate cut may not have much additional impact.
RBI’s Measures to Speed up Transmission
The RBI has recognised these issues and has taken several steps to reduce transmission lag:
Introduction of External Benchmarking
Since 2019, all new floating rate loans for the retail and MSME sectors must be linked to external benchmarks, such as the repo rate. This was a significant move aimed at ensuring quicker reflection of policy changes in lending rates.
Liquidity Infusion Measures
During periods of weak transmission, the RBI often injects liquidity into the system through open market operations (OMOs), targeted long-term repo operations (TLTROs), or reducing the Cash Reserve Ratio (CRR). These steps aim to ease cost pressures on financial institutions and enable faster transmission.
Public Disclosure Norms
By encouraging transparency in rate setting, the RBI hopes to create competitive pressure among financial institutions to pass on rate benefits swiftly.
Why Faster Transmission Matters for the Economy
When monetary policy works quickly and efficiently, it helps the entire economy adjust in a timely manner. Faster rate transmission means:
- Consumers borrow and spend more during a rate cut cycle.
- Businesses plan expansion with greater clarity.
- Inflationary pressures are managed more effectively.
- Economic recovery can be better supported during downturns.
In short, quicker transmission can help the RBI meet its policy goals faster, whether that’s containing inflation or boosting economic growth.
How Does Transmission Lag Affect You as a Borrower/Investor?
As a borrower, the more you understand how this process works, the better prepared you will be to respond effectively. Whether it’s refinancing, negotiating, or simply timing your next big purchase, being aware of transmission delays puts you in control of your financial journey.
While loan rates adjust slowly; deposit rates, including those on fixed deposits, also respond with some lag. Following an RBI repo rate cut, there is typically a short period when investors can still secure competitive FD rates before banks revise their rates. Consider exploring shorter-term FDs that allow you to benefit from future rate increases. Staying flexible with your investments can help you optimise returns as monetary policy evolves.
