The Reserve Bank of India today kept key policy rates unchanged, but put the onus of further reduction in interest rates on banks. However, most lenders indicated that any such decision will be linked to a fall in the cost of funds.

The only two exceptions were Uco Bank [Get Quote], which announced plans to lower lending rates 50 basis points, and Lakshmi Vilas Bank [Get Quote]. The old-generation private bank said it will lower its prime lending rate 25 basis points to 15.25 per cent with effect from February 7, 2009, while deposit rates were being lowered by 50-150 basis points across maturities.

RBI Governor D Subbarao's 35-page statement on the third-quarter review of Monetary Policy repeatedly touched upon the scope for further rate cuts by banks and said that the full impact of the measures announced by the central bank in the last four months will be felt over the next few months.

At a press conference this afternoon, Subbarao, who has so far refrained from announcing rate cuts in his quarterly policy reviews, said that banks which have cut rates can pare them further. He added that RBI will adjust interest rates at the appropriate time and accord top priority to arresting the moderation in economic growth.

In its review, RBI lowered growth projection for the current financial year to 7 per cent, with a downward bias, from 7.5-8 per cent, in view of the global economic downturn.

The other worries are a rise in sticky assets of banks. The fiscal health of the Centre and the states is also expected to deteriorate as tax collections have dropped and governments have stepped up spending. The Centre's fiscal deficit is projected to rise to 5.9 per cent of the gross domestic product, as against the budgeted 2.5 per cent.

While observing that the flow of non-bank resources to the commercial sector has contracted in recent months, RBI increased its projection for growth in non-food credit from 20 per cent to 24 per cent. Similarly, with banks mobilising more deposits to meet the higher credit demand, aggregate deposits are projected to grow at 19 per cent now, compared with the 17 per cent rise estimated in April.

With inflation expected to decline to below 3 per cent by the end of March, the stock markets saw a silver lining in the review and the Sensex rose over 300 points, though no rate cuts were announced. The only measure that RBI announced today was to extend the special refinance window for banks to meet their liquidity needs by another three months to September 2009.

The steps taken by the central bank in recent months are expected to enhance the flow of money into the system. As a result, the money supply growth projection for 2008-09 was also raised to 19 per cent from 16.5-17 per cent earlier.

RBI's assessment is that the cost of funds for banks will come down as a result of the measures initiated so far, which will release over Rs 3,88,000 crore into the system.

While State Bank of India [Get Quote] Chairman OP Bhatt said that his bank is reviewing rates every week, Bank of India Chairman and Managing Director T S Narayanasami linked a reduction in lending rates to further cuts in deposit rates, which, he added, is linked to a further fall in inflation.

"A cut in interest rates will take place in due course," added Canara Bank [Get Quote] Chairman and Managing Director AC Mahajan. Some like Indian Overseas Bank [Get Quote] Chairman and Managing Director SA Bhat feared losing deposits to small savings schemes which are offering 8 per cent interest.

Standard Chartered Regional CEO Neeraj Swaroop said that banks have been paring rates, though it may not be reflected entirely in the reduction in the benchmark prime lending rate. "BPLR may not be the best indicator. There will be a reduction every fortnight, every month on new loans. It will be gradual," he said while pointing out that the bank has reduced lending rate on mortgages and on corporate loans on a case-by-case basis.