Monetary policy: A blueprint of guidance for banks

The unanimous rate cut by 25 basis points and the continuation with the neutral stance of the policy is a foregone move that the markets have already factored in. However, there are more interesting points of relevance for banks to resurrect their business strategies. Banks should be prepared for more rate cuts in times to come as RBI has decided to use the latitude embedded in the flexible inflation targeting (FIT) framework to monitor the inflation within its glide path of 4 percent +/- 2 percent instead of firmly looking for a midpoint target of 4 percent of CPI inflation on a durable basis.

With CPI headline inflation moderating to 5.2 percent in December from 6.2 percent in October, it is further expected to soften, with the lag impact of low winter vegetable prices lingering for some more time. RBI projects CPI inflation for FY26 at 4.2 percent, indicating that it will stay below the upper end of the FIT target of 6 percent and above the midpoint target of 4 percent.

Looking at the growth prospects firming up from the farm sector and both PMI services for January 25 at 56.5 and PMI manufacturing Future Output Index on January 25 expanding to 65.1 from 62.5 in December 2024, RBI projected GDP for the current year at 6.4 percent and 6.7 percent for FY26. The Economic Survey – 2025 estimates GDP in FY26 to grow between 6.3 to 6.8 percent. The IMF projects India’s GDP to grow at 6.5 percent for FY25 and FY26. RBI’s projection is in sync with the World Bank’s estimate of 6.7 percent growth. However, ADB revised India’s GDP forecast for FY25 to 6.5 percent from 7 percent.

Challenges for banks:

Taking a cue from the policy document, banks should gear up for lower lending rates to push growth as inflation softens. It may not be possible for banks to immediately pass on lower interest rates to term deposit holders as slow deposit accretion continues to pose liquidity risks. While the lower repo rate now brought down from 6.5 percent to 6 percent will re-price benchmark linked loan portfolio impinging upon the interest earnings, the interest outgo on term deposits mobilized at ongoing term deposit rates will continue until maturity. It may, in the near term reduce the net interest margin (NIM) of banks in Q4 of FY25 and Q1 of FY26.

Though the liquidity coverage ratio (LCR) is now comfortable at 128.6 percent as of September 2024, banks will be required to make an additional ‘Run off’ provision of 10 percent on retail deposits linked to digital platforms from April 1, 2025, to withstand sudden withdrawals through digital mode.

Banks continue to face liquidity risks as the outstanding credit and deposit on a YOY basis increased by 11.4 and 10.3 percent respectively as of January 24, 2025, indicating the gulf between the two. The credit-to-deposit (CD) ratio is at 80.8 percent at the end of January 2025.

As far as system liquidity is concerned, it remained surplus from July-November 2024, it turned deficit during December 2024 and January 2025. RBI has suggested that banks more actively trade liquidity among themselves in the uncollateralized call money market to make it deeper and more vibrant for better signals from the weighted average call rate (WACR) trends. Instead, banks are increasingly parking funds in the SDF.

External sector:

Amid the interconnectedness and spillover risks, banks operating in the global financial space should decipher and factor in the external sector risks. The external sector continues to pose greater uncertainty with geopolitical risks embroiled in tariff tiffs with economies turning more inward-looking in the post-COVID world.
It will have ramifications in supply-side risks, imported inflation as crude prices fluctuate and Red Sea conflict persists, more importantly, when the exchange rate pressures oscillate entangled with the winds of foreign investments reshaping. The current account deficit (CAD) moderated from 1.3 percent of GDP in Q2 of last year to 1.2 percent in Q2 of this year.

India receives the largest inflow of remittances of US $ 129.1 billion and forex reserves now at US $ 630.6 billion on January 31, can provide import cover for over 10 months. India’s external debt to GDP ratio at 19.4 percent at the end of September 2024 augurs well. INR depreciated by 3.2 percent against the US dollar since November 6, 2024, the day the presidential election results were announced in the US largely mirroring the 2.4 percent appreciation of the dollar index during the same period.

Way forward:

Besides many policy shifts, the monetary policy thrust on the robustness of digital security is important with the continuing deepening of the digital banking ecosystem. Cyber threats and digital risks are manifesting in newer sophisticated ways evident from the increasing digital frauds. The loss to innocent customers and the engagement of banks to resolve the grievances are mounting up. The concern for the safety and protection of digital users is well highlighted.

The entire regulatory guidance is digital protection-centric. Banks should work in a collaborative mode to ensure that the digital system users are well protected and digital literacy is actively spread. RBI urged banks to participate in the upcoming financial literacy week starting from February 24, 2025, dedicated this year to empowering women with financial literacy.

Understanding the challenges of banks on account of improved prudential standards in the LCR framework and making provisions against the Expected Credit Loss (ECL) framework, RBI assured to strike a right balance keeping in view the benefits and costs of each and every regulation. The consultative process in regulation-making, providing time to REs in implementing the regulations, and smooth transition to adopt better prudential standards will be ensured.

The monetary policy provides a comprehensive blueprint of guidance to the REs where balancing the trade-off between financial stability and efficiency will be the cornerstone. A more robust digital framework will have to be carved out to protect customers in the expanding digital landscape. Banks can take a cue from the narratives of the policy to reshape long-term internal business and growth strategies.