Relaxation in leverage ratio positive move to improve liquidity

Largely in line with the street expectations, the Reserve Bank of India (RBI) cut its repo rate by 25bps for the third straight time to 5.75 percent. The rates are now at the lowest level since September 2010. Further, the RBI's inflation forecast remains well below its comfort level for FY20. However, the growth forecast was reduced for FY20 to 7 percent as against the previous forecast of 7.2 percent.

Muted private consumption growth and investment activity along with benign inflation prompted the RBI to change its focus on reviving growth. Further, a change in policy stance from “neutral” to “accommodative” signals the RBI's intention to increase focus on getting the GDP growth back on track.

Notably, one of the important concerns of banks not passing on the recent cuts was eased as the governor mentioned that banks had transmitted nearly 21bps, and he expected faster and higher transmission by banks going forward.

On an overall basis, the policy was a dovish, which promised enough liquidity in the financial system. However, this was largely factored in by the market, given muted demand sentiments and benign inflation outlook.

Further, to boost the lending activity, the RBI relaxed the leverage ratio (Tier 1 Capital as a percentage of the bank's exposure, as defined under Basel III norms) for the banks. For domestic and systematically important banks, the ratio stands reduced to 4 percent while, for other banks, it has been reduced to 3.5 percent.

The leverage ratio is considered an important supplement to the risk-based capital requirements. Further, it is one the four indicators under the RBI's prompt corrective action (PCA) framework. Hence, the step has been taken for providing financial stability and moving towards synchronisation with Basel III standards.

While it would be difficult to say at this juncture whether it would turn out to be a game changer, this appears to be a positive move since some of the banks, especially the smaller ones that are currently under PCA, would now be able to comply with the leverage framework. Relaxation would allow the banks to lend more from the same amount of capital they hold and drive the credit growth. However, it is important to note that other regulatory parameters like improvement in net NPAs and capital adequacy ratio are also essential for enabling the banks to come out of prompt corrective action (PCA).