Market Microstructure and Monetary Policy

Conventional wisdom holds that the monetary transmission mechanism (MTM)– a collection of pathways that connect the central bank actions such as increasing repo rate to real economic decisions such as taking a home loan–is quite weak in India. In theory, MTM is supposed to act in two separate legs. After the monetary policy committee decides to change policy rate, the RBI conducts liquidity management operations to bring overnight interest rate which happens to be operating target–the weighted average call rate (WACR)–within the policy rate corridor.

Since WACR, at the margin, determines the funding cost to the banking sector, it should ultimately change banks’ benchmark lending rates and affect economic variables like investment and savings etc.

But there is theory and there is practice. Recent repo rate hike by the RBI has been a very different story altogether. After the hike, there seems to be plenty of liquidity in the system. RBI is still conducting reverse repo operations to mop up excessive liquidity.

On the other hand, even before the hike was announced, a number of banks led by the State Bank of India and ICICI, had already increased their lending rates, increasing the borrowing cost both for prospective and existing borrowers.

Rather than the textbook monetary mechanism, interest rates seem determined by the market leader and imitated by other banks. There are striking similarities with  the Stackelberg market leadership model. The bottom line is that market microstructure is an important part of the price formation in Indian banking sector.

In this respect, Urjit Patel committee’s observations about the India-specific peculiarities of the MTM may be recalled:

Significant asymmetry is observed in the transmission of policy rates changes between surplus and deficit modes suggesting that maintaining suitable liquidity environment is critical to yielding improved pass-through.

Could it be that the ‘significant asymmetry’ is less due to liquidity environment and more due to market structure? The hypothesis can not be ruled out.


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