Banking & Research - V

Monetary policy is known to have short and long-term effects. Traditionally, monetary policies have been aiming at promoting growth, achieving full employment, smoothing the business cycle, averting financial crisis, and stabilizing long-term interest rates and real exchange rates. Ideally, it would have made greater sense had central banks had a single overwhelming objective of ‘price-stability’.

It is generally believed that the monetary policy actions affect the real sector with lead and variable lags, while its effects on financial markets usually have short-run implications. The lag after which the monetary policy impact is felt on the real sector varies from country to country depending on the kind of transmission mechanism in existence. Secondly, there would always be uncertainties associated with transmission channels depending on the maturity of the financial markets. Central banks, therefore, usually design their monetary strategies and tactics keeping in view the transmission mechanisms that are in operation.

The most frequently used channels for transmission of monetary policy actions are: The quantum channel, the interest rate channel, the exchange rate channel, and the asset prices channel. The impact of transmission of policy impulses through the interest rate channel, the exchange rate channel, and the asset prices are indirect, while the policy impulses transmitted through the quantum channel affect the price level directly.

The exact transmission of monetary policy through these channels is always considered difficult, given the uncertainties associated with the economic system in terms of responsiveness of economic agents to monetary process signals and the ability of monetary authority to assess its impact on others. This phenomenon is much more complex in the context of developing economies since they are constantly in the process of evolution.

In view of these uncertainties associated with the transmission of monetary policy initiatives, central banks in industrialized countries are often found using market-oriented instruments to influence short-term interest rates. In the process, they would supply liquidity to the money market at a price, which they intend to set as a target interest rate with a hope that it would ‘pass through’ the system to influence the array of short-term money market rates set by banks and other financial intermediaries. In other words, if the monetary policy actions are to be effective, the official rate changes should be completely ‘passed through’ to the market and the retail rates over a reasonably short period. As against these theoretical underpinnings, practical experience indicates that the official rate changes do not always instantaneously transmit to retail rates within a short period of time. Earlier studies carried out by Paisley (1994) and Heffernan (1997) using conventional linear methods to investigate these relationships have given mixed evidence for the ‘pass through’.

Incidentally, the RBI Annual Report 2003-04 echoes a similar observation pertaining to India: “The key issue confronting the conduct of monetary policy through the LAF operations is to transmit short-term interest rate signals to the long end of the yield curve. This process will determine the efficacy of monetary policy in pursuit of macroeconomic stabilization. Some preliminary results from work in progress indicate that during April 2000 to March 2003, a 100 basis points reduction in the Bank Rate led to about 40 basis points moderation in the Prime Lending Rate (PLR) in the same month and by another 38 basis points in the subsequent months. As regards the ‘pass through’ to yields on government securities, a 100 basis points reduction in the Bank Rate induced a moderation of 66 basis points in the yield on a 10-year government paper in the same month. Thus, policy signals have an impact on the yield curve and the PLR in the desired direction albeit at less than the desired pace”.

The paper entitled “Base Rate Pass-through: Evidence from Banks’ and Building Societies’ Retail Rates” by Prof. Paul Mizen and Prof. Boris Hofmann provides a theoretical and econometric framework for assessing the commonly prevailing belief that the base rates ‘pass through’ to retail rates by using 14 years of monthly data for interest rates on deposit and mortgage products offered by the UK banks and building societies. The study reveals “complete ‘pass through’ to be the norm in the long run for deposit rates, but not for the mortgage rates”. It is also revealed that the “endogenous and exogenous non-linearity’s increase the adjustment speeds of retail rates to base rates quite dramatically when the ‘gap’ between the retail rate and the base rate is widening but slowdown the adjustment when base rates are moving in a direction that will ‘automatically’ close the gap”.

The need for a sound financial system has perhaps led to a more regulatory intervention in the banking industry than anywhere else. Traditionally, this interference has been mostly in the form of the ‘command and control’ type, but owing to the embedded informational asymmetry, adoption of such an intervention has been found to create moral hazard problems, resulting in the emphasis being shifted to the “incentive compatible” approach. Though this approach sounds theoretically superior, it has its own share of practical problems such as the very limited scope for back testing, a model relating to prediction of very large risks that are potentially the most dangerous for the solvability of banks. In this context, “command and control” type of regulation continues to be the normal style of regulatory intervention under which “capital requirements” have emerged as the most important regulatory investment. But some studies have revealed that capital requirements affect the profitability of efficient banks more than inefficient banks. This finding has now been questioned by Peter JG Vlaar in his article, “Capital Requirements and Competition in the Banking Industry” with a firm conclusion that the distortionary effects of capital requirements are mild.

As a sequel to this, the article, “Issues of Political Economy in Banking Regulation: A Survey”, presents an overview of the current status of the regulatory intervention by the government agencies in the banking industry across the globe under the heads: Rationale for banking regulation, instruments of banking regulation, endogenous regulation, failure of government in regulating banking, and banking regulation as a dialectic process.

The article “Efficiency and Profitability in Indian Public Sector Banks” attempts to analyze the operating efficiency and its relationship with profitability in the Indian public sector banking industry by using the statistical tool known as ‘Data Envelopment Analysis’. The study revealed that the banks affiliated to the SBI group are more efficient than the nationalized banks. It also revealed that the profitability significantly influences the operating efficiency.

Keeping in view the current growing momentum of the wireless revolution and the mCommerce explosion, the last article of this issue, “Reconsidering the Challenges of mPayments: A Roadmap to Plotting the Potential of the Future mCommerce Market” discusses the current status of mCommerce and the expected growth potential for mPayment in the coming decade. The paper attempts to trace the key challenges to successful mPayments particularly in the absence of common standards. To sum up, the article provides “an insight into the key challenges surrounding the mPayments’ environment, with a view to providing a framework for reassessing the future directions for a more successful market”.

IUPJBM Vol. II No.4 Nov, 2003