Policymakers’ Catch-22 With Bank Capital
A road traffic sign sits on display at Canary Wharf in London. (Photographer: Simon Dawson/Bloomberg)

Policymakers’ Catch-22 With Bank Capital


Monetary transmission, financial stability, and the role of bank capital.

The challenge of poor monetary policy transmission has vexed the Indian central bank. Despite significant cuts in policy rates, the volume of lending to the commercial sector has not picked up. Nor has there been a commensurate decline in the price of loans. The whole purpose of cutting the policy rate is to stimulate lending, which is then expected to drive economic growth.

Monetary policy transmission occurs through multiple channels—banking, bond markets, foreign exchange, and real assets. In India, the banking channel is by far the most important one as the other channels are either underdeveloped or regulated such that their role is minimal. The Reserve Bank of India has made regulatory interventions in the banking channel that would improve policy transmission such as the mandatory use of external benchmarks for loan pricing.

The challenge of monetary policy transmission through the banking channel has also attracted academic attention and has been extensively researched. Several factors that could contribute to the poor monetary transmission through the banking channel—such as the level of NPAs, GDP growth rate, bank profitability, concentration in the banking sector, etc.—have been examined.

Capital Requirements: Double-Edged Sword?

One factor that has received special attention is the level of available capital in the banking system relative to the regulatory minimum. This research has generally concluded that a weakly-capitalised banking system, where levels of capital in banks are closer to the regulatory minimum, tends to be poorer in transmitting monetary policy compared to a well-capitalised banking system.

This conclusion is intuitive—if banks have available capital buffer over the regulatory minimum they will find it easier to make incremental loans and those loans would be made at rates that reflect policy rate changes. Thus, higher the level of capital in the banking system relative to the regulatory minimum, better would be the monetary transmission in declining interest rate regime, all other factors being constant.

A corollary of this observation is that monetary policy transmission would be aided by lower regulatory capital requirements that are easy for banks to comply with and hence respond to monetary policy changes more effectively.

However, prescribing a minimum level of bank capital is a critical instrument for the banking regulation that is guided by the objective of financial stability. A large number of research studies have looked at the role of bank capital in maintaining financial stability. The core learning from these studies is that while a higher level of bank capital may not reduce the likelihood of a financial crisis, it certainly reduces the damage a banking crisis can cause to the financial system and the broader economy.

In essence, bank capital works like airbags in a car. Airbags do not reduce the likelihood of an accident but certainly reduce the damage to the passengers should the car get into one. As we saw during the global financial crisis, damage to the macroeconomy from a financial crisis can be severe and stress public finances for years. This has led to some academics demanding very high levels of minimum regulatory capital for banks, as high as 20 percent of risk-weighted assets.

It would appear, therefore, that there is an inherent conflict in the objectives of monetary policy and banking regulation when it comes to bank capital.

Monetary policy transmission would be improved with lower levels of regulatory capital whereas banking regulation guided by financial stability would want higher levels of bank capital.

The RBI is what is often called a ‘full-service’ central bank. It defines monetary policy and implements it, and it is also the banking and financial sector regulator, in addition to being the public debt manager and payment systems regulator. For a full-service central bank, this conflicting view of bank capital between monetary policy and financial sector regulation is especially challenging.

Historically, RBI seems to have weighed in on the side of financial stability and has demanded relatively high levels of regulatory capital when compared with other large banking systems. However, as we move into an era of low-interest rates and growing reliance on monetary policy to stimulate growth, the constraints of bank capital of efficiency of monetary policy are becoming more visible.

The Cost Of Government-Ownership

In India, there is an added layer of complexity where two-thirds of the banking sector is owned by the government that has the primary responsibility of providing capital to the banks it owns. A large amount of capital infusion into banks is a serious fiscal drag on the government. However, if the banks have low levels of capital, any action of the monetary policy of reducing interest rates could be blunted due to poor transmission.

The government wants to pursue fiscal consolidation and contain levels of fiscal deficit which limits its ability to provide capital to banks. On the other hand, if the government lets go of its fiscal deficit targets to infuse large amounts of capital in banks, it could build inflationary pressure and pose new challenges for monetary policy. The recent Financial Stability Report of the RBI mentions the possibility of a further increase in levels of non-performing loans in banks. This would worsen the capital situation and aggravate the problem of monetary transmission.

Since the global financial crisis, economies across the world, including India, have relied almost exclusively on monetary policy to stimulate growth.

However, a full-service central bank, overwhelming government ownership of the banking sector, and banking as the predominant channel of monetary transmission presents a unique challenge and reduces the efficiency of monetary policy.

Anemic growth despite a sharp cut in policy rates over the last year or so is evidence of this challenge.

This means that calls for further policy rate cuts to stimulate the economy are misplaced. We may have seen the limits of what monetary policy action alone can achieve. Fuller transmission of all the policy action taken so far, given the idiosyncrasies of the Indian banking channel, will require shoring up capital levels in government-owned banks and revival of their risk appetite. We need efforts on the fiscal side to make monetary policy work.

Harsh Vardhan is Executive-in-Residence at the Center for Financial Studies of the SP Jain Institute of Management Research. The author thanks Prof. Rajeswari Sengupta for valuable comments.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.

BQ Install

Bloomberg Quint

Add BloombergQuint App to Home screen.