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Monetary Policy Scepticism

Commercial Banks and Monetary Policy in India by Partha Ray

Monetary Policy Scepticism

a K Pat

ew of the financial systems in the world have been repeatedly subjected to as close a study and critical assessment as the Indian financial system has been, both on individual initiative and at the official levels. The corrective and proactive measures taken to calibrate the system in the light of the study findings, in particular with reference to the banking sector, from time to time seem to have helped the country resist the contagion from the east Asian crisis of the mid-1990s and the recent financial turmoil that emanated from the United States (US).

Monetary Transmission

This book represents a recent contribution to the literature on the subject. The objective of this study in the words of the author Partha Ray is that the monetary transmission mechanism is considered a “black box” in that much is known about the influence of money on the working of the economy, but little is known about how exactly it influences the economy. Therefore, he has embarked on a mission to study, using quantitative techniques, the transmission of monetary policy impulses through the credit channel, one among the various monetary transmission channels. More specifically, this book is about interaction of monetary policy and banking behaviour in general, and bank credit, in particular.

The textbooks typically identify five steps of monetary transmission: a change in bank reserves by the central bank leads to multiple change in money supply, to a change in interest rates and credit availability, to changes in investment spending, and finally, to responses of output employment and inflation. The extent and manner in which these motions are indeed taking place in the economy need to be investigated.

The subject matter of the book has been developed against the backdrop of radical changes in monetary policy as reflected in

book review

Commercial Banks and Monetary Policy in India

by Partha Ray, Academic Foundation, 2008; pp 279 , Rs 795.

the relaxation of interest rate policy easing of statutory preemptions, creation of a competitive environment for banks to operate and introduction of prudential measures to bring about greater financial discipline. The book presents a detailed empirical study, using econometric tools, on the impact of the Reserve Bank of India’s (RBI) mone tary direct policy instruments on commercial banks operations (ownership as well as size-wise, and portfolio-wise) and with reference to the concepts of liquidity constraints and capital constraints in the period 1991-92 to 2003-04.

Theoretical Aspects

The chapter on commercial banks and monetary policy traces the theoretical aspects of transmission mechanism and provides a critique of the IS-LM model. It also evaluates the impact of certificate of deposits (CDs) and commercial paper (CP) on monetary policy stances and concludes that there could be an independent credit channel and independent role for banks in transmitting monetary policy although new financial instruments like CDs and CPs have the potential to be substitutes for bank credit.

In the next chapter, on monetary policy and bank behaviour in India, the author provides a detailed and useful account of various banking policies adopted during the period 1992-93 to 2003-04. This is mostly descriptive on the lines of the official RBI documents. This was a period when decontrol in certain areas was accompanied by stricter norms on capital adequacy and provisioning. The RBI generally followed an expansionary policy. Although reduction in the statutory requirement created lendable resources, imposition of prudential norms could have made granting of loans difficult. However, this contention is not borne out by the statistical data on interest, income, advances, etc; furnished elsewhere in the chapter.

The question of the impact of central bank’s policies on the commercial banks’ balance sheet variable is addressed in the chapter on a macro view of monetary policy and banks balance sheets. The experiences in a few countries are discussed to introduce the matter. In India, the author opines the impact of monetary policy on commercial banks has not been subjected to any serious study, perhaps, because of the predominance of public sector banks in the well-regulated banking sector, although in recent years, a few researchers have evinced interest in the bank portfolio behaviour. The author here has deeply probed the influence of monetary policy on balance sheet variables such as deposits, credit and investments, the cash reserve ratio (CRR) as a policy variable and ouput and price indicators. The study throws up interesting results. For instance, contractionary monetary policy has actually resulted in an increase in bank credit, initially as the banks preferred to insulate their loan portfolio, while letting the investments to take the burden for a good time, during 1992-04. Following CRR increase, aggregate deposits tended to spurt briefly before tapering off. Does the perverse effect on bank advances of tight monetary policy suggest that the policy has failed to achieve the desired results as the banks sought to bypass it through non-deposit resources? Is this perverse behaviour true in the case of different types and sizes of banks?

Examining Banks’ Responses

The next two chapters, which constitute the heart of the book, are devoted to a detailed examination of the responses of banks having regard to their characteristics like size, liquidity capitalisation and type of ownership. After presenting a survey of the results of studies dealing with differentials in the impact of monetary policy in India and abroad, the author proceeds to study how far the ownership structure of banks has affected the transmission of monetary policy.

The analysis covers four types of banks: the State Bank of India (SBI) and its

Economic & Political Weekly

JUly 18, 2009 vol xliv no 29


associates, nationalised banks, foreign banks and other scheduled commercial banks. The responses to policy measure like the CRR, as reflected in the balance sheet variables such as deposits, credit, and investments are studied. While the pattern of behaviour of deposits was almost similar across the banks, the advances of nationalised banks and foreign banks showed a rising trend, for a brief period of 12 months. In the case of SBI and its associates, the spurt in advances was shortlived. Investments, in general, exhibited a downward trend in all the bank groups. In the case of private banks, the behaviour was somewhat variance with other banks. A detailed explanation has been provided for the not so uniform responses from the bank groups to changes in monetary policy measures.

The author, however, notes that the evidence obtained was weak and ownership does not explain away the perverse result of the policy stance. The study, therefore, proceeds to enquire with the aid of econometric models how far size, liquidity and capital determine the influence of monetary policy in the chapter entitled “Size, Liquidity and Capital, How Do They Influence Bank Credit?” The conclusions of the study are instructive. At the macro level, an increase in CRR caused a reduction in credit expansion. However, it is revealed that larger the bank, the higher its ability to skirt the tight policy stance. Similarly, banks with higher liquidity or good capitali sation were in a position to protect their lending policy or bypass the intended effects of changes in monetary policy. Inflation and economic growth had a positive impact on loan disbursement. Capital-constrained banks like small public and private banks bore the burden of contractionary monetary policy. Less liquid banks were largely affected by monetary policy actions.

This could imply that in the regime of tight monetary policy, it is the small and medium borrowers in agriculture, trade and industry in the non-corporate and informal sectors, who seem to suffer the most. The large borrowers in industry, agriculture, trade, real estate, etc, were by implication, not much affected by a contractionary policy because they generally


bank with large public sector banks, new private sector banks and foreign banks. Won’t it lead to a unequal distribution of bank credit? Is it not in addition to the distortion in interest rates with the small borrowers ending up by paying higher interest rates? This crucial research finding indeed calls for a policy response from the RBI. Partha Ray, who has been enjoying a ring-side view of policymaking in the central bank could have speculated on how the distortion could have been combated through policy. In the concluding chapter, the writer takes a peep into the futuristic, evolving banking scenario and also outlines the area for further research.

This is a good book for what it says and what it represents. Well-written and wellproduced. The study elegantly combines theory and empiricism. A serious book containing serious subject matter, which has been skilfully and professionally handled. This is a noteworthy contribution from an enquiring mind to a better understanding of monetary policy transmission.


JUly 18, 2009 vol xliv no 29

Economic & Political Weekly

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