Heartburn at lenders as loan rates fall but deposit rates don’t

In a meeting with RBI officials about 10 days ago, ahead of the monetary policy outcome on 5 December, multiple state-owned bank chiefs raised concerns that the dominance of external benchmark-linked loans has ensured instant repricing of assets whenever the repo rate moves, said the three people cited earlier.

In contrast, only fresh deposits are repriced, and at a much slower and costlier pace, said the people, who didn’t want to be identified as the discussions were private. This has thinned banks’ net interest margins.

“We have passed on 100 bps (basis points) of cuts on the asset side but have been able to reduce deposit rates by only 30 bps, creating a 70-bps spread compression, and this gap cannot be adjusted through ALM (asset-liability management) alone. Every bank has conveyed this to RBI,” said a senior state-owned bank official, one of the three people quoted earlier.

So far in 2025, the Monetary Policy Committee has cut the policy repo rate by 100 basis points to 5.5%. A Mint poll of 13 economists showed that nine expect the rate-setting panel to keep the rates steady on Friday, while four expect a 25 bps cut. The regulator usually meets bankers ahead of the policy meeting.

A query emailed to RBI did not elicit a response until press time.

Bankers say that RBI’s push to link retail and small business loans to an external benchmark has made lending portfolios highly sensitive to policy moves.

About 63% of all floating-rate loans are linked to an external benchmark like the repo rate, resulting in a near-immediate transmission of policy rate changes. Deposits, however, are on fixed rates, and rate changes only apply to fresh ones.

Public sector banks have a higher proportion of floating loans linked to the marginal cost of funds-based lending rate (MCLR). This benchmark is linked to deposit rates. In comparison, private sector banks have almost 88% of their floating loans tied to external benchmarks, impacting them more than state-owned peers.

While the transmission on fresh deposits has been complete, existing deposit rates have dipped by 31 bps since the first rate cut in February, to 6.78% in October. On existing loans, the rate has fallen by 63 bps, showed data from RBI.

Rates on the existing deposits only fall when older, costlier deposits mature.

“This is the fundamental asymmetry,” a senior treasury official said. “If ₹100 of deposits are on the books, barely ₹10 comes up for repricing in a given month, while ₹60 out of ₹100 in loans get repriced instantly. Full transmission on the liability side is mathematically impossible.”

Banks have been struggling to boost deposit growth as competition for household savings has intensified over the decade. Mutual funds, which were only 12.6% of bank deposits a decade ago, now account for more than one-third of that size. Financialization of savings into equities, debt funds, insurance products and government-backed schemes has also diverted flows away from bank fixed deposits, squeezing current account and savings account ratios.

Banks also pointed to regulatory factors exacerbating the issue. High runoff factors under the liquidity coverage ratio (LCR) framework mean that short-term deposits, including certificates of deposit (CD), carry runoff assumptions of 40% to 150%, sharply raising liquidity buffers and, in turn, the cost of funding.

The runoff factor is a percentage of deposits a lender expects to be withdrawn during liquidity stress.

“Even if I raise CDs, liquidity is only stable for one or two months. We end up borrowing more to maintain LCR, which drives the cost of funds up,” the official quote above said.

What can aid transmission?

RBI could support transmission by infusing liquidity in the banking system, according to economists. As of 1 December, liquidity in the banking system was in surplus of ₹2.58 trillion.

“To ensure that the transmission isn’t undone, deposit growth needs to pick up. For this, the cost of liquidity and the quantum of liquidity is important. RBI liquidity management has already begun to address this. For deposit growth to pick up, the banking system liquidity surplus needs to be substantial on a consistent basis,” said Gaura Sengupta, chief economist at IDFC FIRST Bank.

“RBI will need to infuse ₹2 trillion of liquidity to ensure core liquidity doesn’t drop below 1% of NDTL (net demand and time liabilities) by March 2026,” Sengupta said.

As core liquidity has dipped to 1.5% of NDTL, system liquidity surplus tends to fluctuate with government expenditure. Looking ahead, there will be a further drain on liquidity from currency leakage, which tends to pick up in Q4 and drain from RBI’s forex operation, she said.

Bankers said there are several interventions that could rebalance transmission in the coming quarters, including a three- to four-year “roadmap” for policy rates to guide liability pricing. “If repo changes unpredictably every two–three months, we cannot plan deposit pricing,” the person quoted above said.

Seen as the single biggest lever, a reduction in small savings interest rates would allow banks to garner more deposits without losing savers.

“More than policy interventions, the small saving interest rate of the government of India has to come down. This will help liabilities,” another banker said.

Small savings schemes have turned stickier after successive hikes, offering 8.00–8.50%, significantly higher than bank term deposit rates.

Some bankers suggested exploring globally common products, such as floating-rate deposits, which adjust in line with benchmark rates, enabling faster transmission.

“Floating-rate deposits, market-linked retail liabilities and new savings products could mirror the rapid repricing seen on loans,” a treasury official said.