Banks and the High Interest Rate regime

The problem of high inflation with low economic growth rate has been plaguing Indian economy for some years now. Much is said about the high interest rates that banks have been charging in this regard.

The issue of inflation is interpreted differently by the different central authorities. For the Reserve Bank of India, the problem of inflation is a case of excess demand over supply in the economy. Over the last few years, the RBI, being a monetarist institution, has used its policy rates (CRR, Repo rate, Reverse Repo Rate, SLR, etc) to try fight inflation by reducing money supply and thereby overall demand in the economy. As a result, it has imposed a high interest rate regime on the banking sector.

For commercial banks, the going has not been well in the post global crisis period. Given the deterioration of economic activities, net Non Performing Assets have been increasing, cost of funds for banks have been rising, profitability in terms of Return on Assets have been falling. Consequently, Net Interest Margin (NIM) has been lowered.

NIM refers to the difference in interest rates between what the banks charge from borrowers and what they pay to depositors. Given high inflation rates, no one would deposit money if interest rates the banks offer are too low. But falling NIM means that banks cannot lower interest rates they charge from borrowers without affecting their own health.

Indian banking sector is thus presently trapped in a Catch 22 situation over interest rates.

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