India’s financial sector is largely bank-based, with limited overall access to capital markets. Since commercial banks mostly fulfil the credit needs of households and businesses, the bank lending channel plays an important role in monetary policy transmission. Bijoy Rakshit and Samaresh Bardhan write that in periods of banking consolidation, the concentration of market power in fewer hands weakens monetary policy transmission.

Traditionally, policymakers and researchers have identified four key channels of monetary policy transmission: interest rates, credit, asset prices and the exchange rate. More recently, a fifth channel, expectation, has been added. Collectively, these channels are known as the “transmission mechanism“.

While the channels work in tandem, the discourse of monetary policy has largely been dominated by interest rates. Beck et al. (2014) suggest that the role of commercial banks should be given due importance, owing to their ability to influence monetary policy transmission through lending (the credit channel). Unlike interest rates, bank lending considers bank-specific characteristics such as size, liquidity and capitalisation. Here the focus is mostly on the possible effects of monetary policy actions on the credit supply. To justify the existence of bank lending as a channel, there should be adequate empirical evidence showing how monetary policy actions influence bank loan supply and demand.

Bank competition and monetary policy transmission

Since the Great Depression and recently in the wake of the Global Financial Crisis, monetary easing has been viewed as a key stimulus to boost investment and address difficult economic situations. However, there has been broad consensus that its expected benefits do not reach all markets evenly. For example, the International Monetary Fund (IMF, 2012) expressed serious concern over monetary easing as it allows large corporations to access bank credit at record-low interest rates while small firms struggle for formal bank loans. Similarly, the Federal Reserve Bank of New York revealed that the purchases of mortgage-backed securities by the central banks did not lower primary mortgage rates partly because of higher interest margins exercised by banks with increased market power. Motivated by these concerns, we examined the idea of whether bank competition influences the transmission of monetary policy in an emerging economy such as India.

A flourishing body of literature has established the theoretical associations between bank competition and monetary policy transmission through the bank lending channel. Bernanke and Blinder (1988, 1992) argue that a competitive banking industry with restricted access to funding sources other than customer deposits is more responsive to an expansionary as well as a contractionary monetary policy. It happens because intensified bank competition, typically characterised by fewer restrictions, fewer barriers to entry and a liberal branch licensing policy may push the weaker and less efficient banks (reliant on deposit finance mostly) out of the market, making the bank lending channel responsive to monetary policy changes.

Banks exercising higher market power (less competition) are endowed with easier, superior and alternative access to uninsured finance, making them less dependent on central bank funding in times of monetary tightening. Increased market power affects monetary policy transmission through two additional channels: the deposit and loan markets. Drechsler et al. (2017) write that with an increase in interest rates, banks have the tendency to widen deposit spreads, which often results in deposits flowing out of the banking market. Since customer deposits constitute a substantial part of bank loans, the outflow of deposits restricts lending. The study argues that bank lending concentration occurs mainly due to perceived market power over deposits.

Similarly, Scharfstein and Sunderam (2016) suggest that banks’ market power stifles the effective transmission of monetary policy, as the pass-through of policy changes is not as quick in a concentrated banking system as in a competitive one. However, contrary to the theoretical arguments of Drechsler et al. (2017), Repullo (2020) shows that in imperfect competition, a contractionary monetary policy can have ambiguous effects on the equilibrium amount of deposits. Repullo’s study suggests that the relationship between a tighter monetary policy and the equilibrium amount of deposits is rather U-shaped – first it decreases and then increases.

The Indian case

India is one of the fastest-growing emerging economies in the world. The country’s financial sector is largely bank-based, with limited overall access to capital markets. Since commercial banks mostly fulfil the credit needs of households and businesses, the bank lending channel seems to play an important role in monetary policy transmission.

The Indian banking sector has undergone multiple phases and experienced considerable variations in the degree of competition since the financial liberalisation of 1991. During the phase of first-generation economic reforms (1991-1997), several deregulatory measures were implemented, including open entry for private banks, aggressive bank-branch expansion, abolition of administered interest rates, a larger presence of foreign banks and fewer activity restrictions. These measures intensified bank competition to a significant extent.

The second-generation economic reform measures adopted post-1998 involved bank consolidation through mergers and acquisitions. The main purpose of consolidation was to ensure stability. The process was well evident in the declining numbers of total competitors (Jayadev and Sensarma, 2007). The mixed episodes of bank competition and consolidation extend an interesting empirical set-up to examine whether bank competition affects the transmission of monetary policy through the bank lending channel in India.

Different ownership structures

Unlike in advanced economies, commercial banking in India is dominated by public sector banks, which exercise greater autonomy and a higher degree of market power in their lending decisions than private and foreign banks. Public sector banks meet most of the credit demand for firms and households and therefore are subject to greater monitoring and scrutiny. Additionally, banks with other ownership structures have different customer bases and differ from each other with respect to several other factors that influence their lending decisions.

For example, with deposit growth outperforming loan growth at the aggregate level, the loan-to-deposit ratio declined significantly to 64.12 per cent in 2021 from 75.14 per cent in 2012 (Reserve Bank of India, 2021). This decline appears to be a matter of concern and motivates us to examine whether concentration in the deposit market contracts public sector banks’ lending.

In response to the changing macroeconomic environment, the monetary policy’s operational framework has undergone surprising changes over the past decades. The framework has also evolved in terms of monetary instruments, its several channels and targeting mechanism. In the Indian context, most studies on monetary policy focus on the interest rate channel, paying little attention to bank lending. Literature is scant when it comes to examining the role of bank competition in the monetary policy transmission mechanism.

Empirical evidence and policy suggestions

Our findings suggest that the Indian commercial banking system has remained competitive over the years. However, there is evidence of concentrated market power during the  consolidation phase. As expected theoretically, a higher degree of market power, with lesser competition, weakens monetary policy transmission. Competition and market power indicators are crucial for such an analysis.

We offer some policy suggestions to enhance the effective implementation of monetary policy. Scrutiny of the functioning of the banking system—including the deregulation and consolidation measures that affect competition—is critical. The monetary authority should enact policies that can offset the adverse effects of changes in competition conditions on monetary policy transmission. Pro-competitive policies should be adopted for private and foreign banks. These policy suggestions could be useful for other emerging economies that witnessed a similar experience of bank deregulation and increased competition conditions.

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Notes:

• This blog post is based on Does bank competition affect the transmission mechanism of monetary policy through bank lending channel? Evidence from India, Journal of Asian Economics.
• The post represents the views of its author(s), not the position of LSE Business Review or the London School of Economics.
• Featured image by rupixen.com on Unsplash
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