The world over, central banks are taking full advantage of the sharp decline in inflation to slash their policy interest rates and reserve ratios. The US Federal Reserve recently brought its benchmark federal funds rate to a target zone of 0-0.25 per cent, the lowest it has been in over 50 years. The Bank of Japan followed suit by bringing its rate down to 0.1 per cent. Both institutions are also looking at ways in which they can shore up their delicate financial systems by buying up or lending against new kinds of securities.

In India, virtually everybody expects the Reserve Bank of India [Get Quote] to significantly cut its own repo and reverse repo rates in the next few weeks; unlike the central banks of the US and Japan, it has significant room to do so, with the rate currently set at 6.5 per cent. But this is where the concerns about effectiveness become significant. Indian banks seem to be reluctant even now to lower their own lending rates (some private banks even now have prime lending rates that are a stratospheric 16 per cent). If rates don't fall in the debt market, all the RBI's moves will become ineffective and there will be a rapid erosion of confidence in the ability of the economy to recover from the current slowdown.

There are a number of perverse incentives that encourage banks to do the precise opposite of what they need to do to stimulate growth. For the system as a whole, the prospect of interest rates declining over the next several months as a result of the RBI's policy stance makes holding government securities rather attractive. Securities held over and above the statutory liquidity requirement are marked to market. As interest rates fall, the value of these securities rises and the entire gain is recognised as income, enhancing profitability.

This is similar to the situation of a few years ago, when banks saw an enormous increase in returns from their portfolios of government securities, making them indifferent towards growing their lending activities and leading to them being accused of 'lazy banking.'

Unfortunately, the incentive to become lazy once again comes at a time when the economy can least afford it. Compounding this problem is the sharp distinction that has emerged between public and private banks. A flight to safety amongst depositors has resulted in a significant re-allocation of funds from the latter to the former. This has, in turn, led to a large gap between the benchmark prime lending rates of leading banks in the two categories.

Business Standard has long been critical of the government's tendency to tell public sector banks to lower their lending rates, even what rates to charge -- not least because, often enough, the banks don't pay attention. Regulatory intervention is clearly warranted, but instead of telling banks what to do, the government and RBI need to address the underlying reasons why banks are not lending as much as they can. An effective tactic would be to announce a sudden drop in interest rates, to prod banks into action; another would be to develop an active bond market so that companies can approach the market directly for funds.