For the first time in five years, the Reserve Bank of India (RBI) has lowered its key interest rate, i.e, the repo rate, by 25-bps, bringing it down to 6.25 percent. This move comes as India’s economic growth slows, inflation eases, and urban spending declines. The rate cut follows significant tax reductions announced in the Union Budget just a week earlier and is expected to make borrowing cheaper for home, car, and other loans.

Will Banks Pass on the Rate Cut to Borrowers?

The big question now is whether banks will reduce loan interest rates in response. When the RBI lowers the repo rate, banks are generally expected to follow suit by cutting lending rates. However, this does not always take place immediately, and banks often pass on only a portion of reduction. The RBI has faced this issue before, as delays in rate transmission weaken the intended benefits for the economy and inflation control.

Why Loan Rates May Take Time to Decrease

Experts believe it could take months for bank loan rates to fully reflect the rate cut. This is because banks are dealing with a shortage of funds, intense competition for deposits, and high operational costs. While borrowers with repo-linked loans may see an immediate reduction in rates, those with loans based on the Marginal Cost of Funds-Based Lending Rate  will have to wait longer. Since MCLR-linked loans reset every 6 months, any changes may only take effect in January or July, depending on the reset period.

How Banks Are Responding

Even before the RBI’s rate cut, many banks had already been shifting toward MCLR-linked loans to protect their earnings. Unlike repo-linked loans, which reflect rate cuts quickly, MCLR-linked loans take time to adjust. To address this, the RBI introduced the External Benchmark Linked Rate system, which ensures faster transmission of rate cuts. However, many banks use to keep repo-linked interest rates higher than MCLR-linked rates, limiting the immediate benefits for borrowers.

Liquidity Issues May Delay Rate Cuts

Another major factor affecting loan rates is liquidity, ie.the availability of money in the banking system. Experts warn that by March 2025, the banking system could face a liquidity shortfall of up to Rs.2.5 lakh crore unless the RBI takes further action. If this happens, banks may struggle to pass on the rate cuts effectively.

Some bankers had already suggested that the RBI should inject more funds into the system to ensure quicker transmission of rate cuts. In line with it, the RBI has infused Rs.1.5 lakh crore into the market. After announcing the rate cut, RBI Governor Sanjay Malhotra assured that the central bank will continue monitoring the situation and take necessary steps to maintain liquidity.

Is Govt Monitoring Banks?

The government is keeping a close watch on banks to ensure they pass on the benefits of the rate cut to borrowers. A banking source said that discussions will be held with banks if loan EMIs do not reflect lower rates soon. While there is no strict deadline, the government expects banks to make reasonable reductions in borrowing costs.

A similar situation occurred in 2019 when the RBI cut rates by 25 basis points, but banks reduced their lending rates by only about 5 basis points. At the time, the then RBI Governor Shaktikanta Das had to step in and address the issue with banks. This time, the government may take similar action if banks fail to pass on the rate cuts fairly.