A Theoretical and Empirical Analysis of Interest rate pass-through in India with Regulatory Requirements

Abstract

Özet: This study provides a theoretical and empirical analysis of optimal loan pricing by the commercial banks in a regulated environment that could relate to some developing and emerging market economies. Regulatory requirements could impinge on banks’ balance sheet and thus, influence their optimal loan pricing response to the policy rate. In such a situation, for an effective transmission mechanism through the interest rate channel, a calibrated approach may be required; changes in the policy rate to be accompanied by changes in the regulatory parameters to achieve desired changes in the banks’ lending rate. Theoretical analysis brought to the fore various critical insights. Three major insights are as follows. First, there can be a trade-off between regulation and effectiveness of transmission mechanism and competitiveness of the loan market. Second, theoretically it is possible for banks to engage in subsidisation of loans against investment in risk free government securities. Third, the capital market could be linked to monetary transmission mechanism if banks were subject to a required return on their capital base. These theoretical perspectives have implications for bank regulation and policy purposes.

Abstract

Özet: This study provides a theoretical and empirical analysis of optimal loan pricing by the commercial banks in a regulated environment that could relate to some developing and emerging market economies. Regulatory requirements could impinge on banks’ balance sheet and thus, influence their optimal loan pricing response to the policy rate. In such a situation, for an effective transmission mechanism through the interest rate channel, a calibrated approach may be required; changes in the policy rate to be accompanied by changes in the regulatory parameters to achieve desired changes in the banks’ lending rate. Theoretical analysis brought to the fore various critical insights. Three major insights are as follows. First, there can be a trade-off between regulation and effectiveness of transmission mechanism and competitiveness of the loan market. Second, theoretically it is possible for banks to engage in subsidisation of loans against investment in risk free government securities. Third, the capital market could be linked to monetary transmission mechanism if banks were subject to a required return on their capital base. These theoretical perspectives have implications for bank regulation and policy purposes.

Keywords

• Money,Interest rate,Credit,monetary policy,Firm objective,Micro theory of pricing,mathematical economics,financial economics

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