Bank Lending - Why Are Banks Raising Lending Rates Amid Dovish Monetary Policy?

At a time when the Reserve Bank of India (RBI) has already cut repo rates by 100 basis points and signaled more cuts ahead, one would expect banks to lower their lending rates. Instead, several banks are planning to raise lending rates to protect their profit margins. Why this disconnect? Let’s break it down.

Why This Disconnect?

When the RBI cuts the repo rate, borrowing costs for banks fall immediately. Logically, banks should pass on this benefit to customers by reducing loan interest rates.

But the mechanism of how rate cuts flow through the system creates a mismatch:

Floating-rate loans: Any change in the base rate must be passed on immediately, whether repo rates rise or fall. Borrowers on floating loans see an instant impact.
Deposits are sticky: Long-term fixed deposits were contracted at higher rates earlier and cannot be repriced unless they mature or are renewed.

This creates a situation where loan yields fall faster than deposit costs, compressing bank profitability.

And, That Is Hitting Bank NIMs

One of the most important profitability metrics for banks is the Net Interest Margin (NIM) - the spread between the average loan rate and the average cost of funds.

With repo rates falling, loan rates drop quickly.
But deposit rates remain high until renewals kick in, keeping funding costs elevated.
Result: NIMs shrink, putting direct pressure on bank profits.

To protect margins, banks are reluctant to cut lending rates further and are even contemplating hikes despite the RBI’s dovish stance.

Adding to the challenge, banks are in direct competition with mutual funds, which currently offer more attractive returns on short-term liquid funds, making it harder for banks to attract fresh deposits at lower rates.

Did We Forget the Good Times?

For borrowers frustrated with rising lending costs, there’s historical context to consider.

Between 2022 and 2024, when repo rates were rising, banks enjoyed a golden run:

Loan rates moved up in lockstep with repo hikes.
Deposit rates lagged, as banks delayed passing higher returns to depositors.
Banks reported record-high NIMs, boosting profitability.

Yet, during this profitable period, few banks proactively reduced lending rates or shared these higher margins with borrowers. That’s why the current squeeze feels like a double standard - borrowers end up bearing the brunt both ways.

It Is About Demand and Supply

Ultimately, interest rates are also shaped by credit demand versus deposit supply.

During the rate hike cycle, loan demand outpaced deposit growth, giving banks pricing power to charge higher lending rates.
In today’s environment, loan growth is more subdued, and deposits are growing steadily. This means banks cannot indefinitely push higher lending rates without hurting credit demand.

The bigger question is about fairness. Should banks be allowed to shield profits at the cost of borrowers, even when the monetary policy is dovish? Or should the RBI intervene to ensure that the system remains equitable?

Final Takeaway

The divergence between RBI’s dovish policy and banks’ lending behavior highlights a structural challenge in India’s financial system.

For borrowers: Expect some near-term stickiness in loan rates, even as repo rates fall.
For depositors: Higher rates on older FDs continue to offer an edge.
For banks: Balancing profitability with fairness will be key to sustaining trust in the system.

The RBI may eventually step in with stricter transmission rules to ensure monetary policy benefits flow evenly to borrowers, depositors, and the economy at large.