Why Are Banks Cutting Interest Rates?

Understanding the RBI’s Policy Moves, Liquidity Boosts and What It Means for Borrowers and Savers

In recent months, a noticeable shift has begun to take place in India’s banking and financial landscape. After maintaining a stable policy stance for a prolonged period, the Reserve Bank of India (RBI) has reduced the repo rate twice in a row, each time by 25 basis points (bps).

These cuts have raised an important question in the minds of many: why are banks starting to cut interest rates now? To understand this, we need to dive into the mechanics of monetary policy, changes in economic conditions, and the broader liquidity situation in the banking system. Moreover, we must explore how these moves affect banks' profitability, the cost of loans, and the returns on fixed deposits (FDs) for everyday investors.

RBI’s Recent Repo Rate Cuts – What Changed?
The repo rate is the rate at which the RBI lends money to commercial banks. It serves as a benchmark for interest rates across the economy. When the repo rate goes down, borrowing becomes cheaper for banks and ideally, this benefit is passed on to consumers and businesses in the form of lower interest rates.

For nearly two years the RBI kept the repo rate unchanged, citing concerns about inflation and global uncertainties. But in its last two policy meetings, it cut the rate by 25 bps each time, bringing it down from 6.50 per cent to 6.00 per cent.

So, why this change in stance?
Easing Inflation: Retail inflation has been trending lower, staying within the RBI’s target range of 4 per cent (+/-2 per cent). Lower inflation gives the central bank more flexibility to boost growth without risking price stability.

Slowing Economic Growth: India's GDP growth has shown signs of slowing down due to weak global demand, uneven consumption recovery, and cautious corporate spending. Lower interest rates are intended to stimulate demand by making borrowing cheaper.

Global Rate Trends: Central banks around the world, including the US Federal Reserve and the European Central Bank, have taken dovish stances. This creates a favourable environment for India to cut rates without risking capital outflows.

RBI's Liquidity Push – Rs 1 Lakh Crore Swap Boost
Alongside the repo rate cuts, the RBI has also taken other significant steps to enhance liquidity in the banking system. One of the most impactful was the recent Rs 1 lakh crore dollar-rupee swap operation.

Here’s how it works:
The RBI conducts a swap by purchasing US dollars from banks and offering them rupees in return, for a fixed period. After that period, the banks will return the rupees and get back their dollars, with a small premium. This mechanism helps inject rupee liquidity into the system without affecting long-term interest rates.

This move has multiple benefits:
It ensures banks have enough liquidity to lend.
It stabilises the rupee by increasing the RBI’s forex reserves.
It reduces short-term borrowing costs for banks, allowing them to lower interest rates on loans.

Debt Risk Weight – A Silent Booster
Another lesser-discussed but crucial factor is the improvement in reduction of the risk weights on bank loans to Non-Banking Financial Companies (NBFCs) and microfinance institutions from 125 per cent to 100 per cent, effective April 1, 2025. Risk weights are regulatory measures that determine how much capital banks must set aside for different types of loans. A higher risk weight (like 125 per cent) means banks must hold more capital for every rupee lent, making lending more expensive and potentially limiting credit flow. Lowering the risk weight to 100 per cent means banks can lend more to NBFCs and microfinance institutions without needing to increase their capital reserves as much, thus reducing funding costs and boosting credit availability.

How Banks Are Affected – Revenue and Margin Pressure
While rate cuts and liquidity infusions are good for the economy, they can squeeze banks net interest margins (NIMs) - a key measure of profitability.

Here’s why:
As loan rates fall, the interest income banks earn from borrowers declines. But banks also pay interest to depositors. If deposit rates don’t fall fast enough, it creates a mismatch. The result, banks earn less profit on every rupee they lend. However, there is a silver lining that is if rate cuts lead to higher credit growth, banks can compensate for lower margins with higher volumes. Liquidity surpluses reduce the need for costly borrowings, helping manage costs. So while profitability may take a short-term hit, banks could benefit over the medium term if demand picks up.

What Happens to Loans – Cheaper EMIs and Easier Credit
One of the most direct impacts of a rate cut is on loans. Whether you're planning to buy a house, car, or fund a business, the cost of borrowing is now going down.

Home Loans: Most banks have already started reducing their lending rates. For example, a 25 bps reduction on a Rs 50 lakh home loan can save a borrower nearly Rs 8,000 per year.
Personal Loans: These may also become slightly cheaper, although banks are usually cautious due to higher default risks.
Business Loans: Lower rates make it easier for businesses to raise capital, invest in new projects, and hire more people boosting overall economic activity.

Importantly, many loans today are linked to external benchmarks like the repo rate or Treasury bill yields. This means the transmission of rate cuts to end borrowers is faster and more transparent than before.

Impact on Deposits – FD Rates Begin to Dip
While borrowers cheer lower loan rates, savers may feel the pinch. Fixed Deposit (FD) interest rates are also falling, and this trend is likely to continue. Banks adjust deposit rates to manage their cost of funds. With lower lending rates, they also reduce the return they offer to depositors. For senior citizens and risk averse investors who rely on FDs for income, this is a cause for concern.

Some banks have already reduced FD rates by 10–25 basis points and further cuts may follow. Investors may need to consider alternatives such as government bonds, debt mutual funds or begin investing in blue chip companies for potentially better returns.

Broader Economic Impact – The Domino Effect
The combination of repo rate cuts, liquidity boosts, and a healthier corporate balance sheet creates a domino effect across the economy:
Improved credit flow helps revive private investment.
Lower EMIs increase disposable income for consumers.
Greater liquidity reduces financial stress among NBFCs and smaller banks.
Stock markets often react positively to rate cuts, as cheaper credit boosts corporate earnings.

However, the effectiveness of these measures depends on transmission. If banks are slow to pass on the benefits or if consumer sentiment remains weak, the full impact may take time to materialise.

Conclusion: What Lies Ahead?
The RBI’s recent actions mark a shift toward a more accommodative policy stance. By cutting interest rates, boosting liquidity through forex swaps, and lowering debt risk weight, the central bank is signalling its intent to fuel growth and ease financial conditions.

For banks, this is both an opportunity and a challenge. For borrowers, this is a welcome relief - EMIs will reduce, credit will be more accessible and businesses may find it easier to grow. But for savers, especially those relying on fixed income, it’s time to rethink strategies as FD returns decline.

In the months to come, the focus will remain on how banks transmit these policy changes to the real economy. If implemented well, this could set the stage for a new cycle of sustainable growth.

Disclaimer: The article is for informational purposes only and not investment advice.